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It’s time to rethink performance fees

The industry has moved on.

In recent years there has been a lot of attention on the costs of investing. Across the world, fees have been coming down due to a combination of competition from low-cost index funds, and pressure from governments and regulators.

Performance fees have come under particular scrutiny. Questions have been raised about both their fairness and their complexity. The performance fees charged by the Allan Gray-Orbis Global Optimal Fund of Funds despite the portfolio’s sustained weak returns once again put this issue in the spotlight this week.

Read: Questions raised about Allan Gray-Orbis performance fees

In South Africa, National Treasury has specifically excluded funds that charge performance fees from being used in tax-free savings accounts because they do not fit with the idea that these accounts should be simple, and low cost.

Yet advocates of performance fee structures continue to believe that they serve the interests of investors. If the asset manager is rewarded for delivering strong performance, they contend, then it’s ultimately the client who benefits.

The Allan Gray story

Allan Gray, for instance, is absolutely sincere in its belief that performance fees are an integral part of why it has been so successful. The firm entered the market at a time when the unit trust industry was dominated by the large insurers, who gave the impression that they were more concerned about selling products than ensuring that their clients benefited from using them.

By putting performance first, Allan Gray disrupted the market to the extent that it grew into the largest asset manager in the country, and has been able to maintain that dominant position for decades. Its use of performance fees, it believes, ensures that this focus is never lost.

However, the asset management industry of today is very different to the one Allan Gray entered in the 1970s. The level of competition is far higher, and delivering performance has become the first criterion by which any firm is judged.

The things that Allan Gray believes performance fees encourage – client-centricity and delivering value – have become what any asset manager has to foreground if they want to be successful and sustainable. Improved transparency in the industry and the rise of index funds have ensured that investors are far more aware of what their options are, and what they should be willing to pay for them.

Can you be better by trying harder?

There is also a growing body of evidence that the skill any asset manager possesses is only a tiny part of determining the return they are able to deliver. In addition, the ability of asset managers to deploy that skill is increasingly diminishing as markets become more and more efficient, and competition between them escalates.

Read:

It’s not that active manager’s have failed…

No fund manager stays on top forever

In other words, there is no reason to believe that any asset manager will deliver better returns just because they are incentivised to try harder. There is no independent empirical evidence that suggests otherwise.

This is why performance fees are starting to appear a little dated. They may have been an appropriate solution to an industry problem that existed 50 years ago, but that problem no longer exists.

On the contrary, it is now becoming well understood that fees themselves are creating the greatest opportunity for industry disruption. Research by Morningstar and other academic sources has shown empirically that the best determinant of any fund’s future returns is the fee that it charges: funds that charge less will deliver higher returns.

Legacy thinking

This is not particularly revolutionary. It’s simply common sense, since every rand an asset manager receives as a fee is a rand taken from the investor’s return.

The irony, therefore, is that firms that charge asymmetrical performance fees and claim this is good for their clients would be delivering higher returns to those same clients if the performance fee didn’t exist.

And that is ultimately where the debate around what is truly in the interests of the end investor has to take place.

Can the interests of an asset manager truly be aligned with those of its clients through performance fees when this unequivocal conflict exists? More and more people in the industry don’t think so.

A number of asset managers in South Africa, including some of the largest firms like Old Mutual and Coronation, have done away with performance fees on many products. A number of boutiques are doing the same. Just this week RECM announced that it will be removing all performance fees from the RECM Global Flexible Fund, the RECM Equity Fund and the RECM Balanced Fund from April 1. The RECM Global Fund will follow suit as soon as it has managed the requirements in Guernsey, where the fund is domiciled.

Read: Coronation’s lower fees are still too high

This is a shift that appreciates that the reality is changing, and that it has to change.

Firms that don’t appreciate this run the risk of being caught in a way of thinking that is no longer relevant, and no longer resonates with investors. No matter how well it might have served them in the past, they have to seriously consider whether it will continue to serve them as well in the future.

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The mornngstar research proves maths : the longterm impact of compound fees.

The part that is illogical about fees is that there is no connection between skill level and scope on the one hand and fund size on the other. It should take as much skill and effort to invest R1m as R1000 million. Yet the fees differ a thousand-fold.

Agree 100% (plus 5% for performance). This is a drum I have beaten for many years. The same applies to “admin fees”. How can a R100m portfolio be more expensive to administer than a R1m portfolio? That would be akin to your doctor that charges double the consultation fee for a 100kg patient compared to a 50kg patient. 🙂

I guess it’s to subsidizes the guy starting with R10 000 a bit, or else he’d have to pay 10% fees, and obviously there is the profit motive, these aren’t charities.

Its easy to spend that money… but gets harder to invest it. As the fund size grows the opportunities for outsized returns diminish … see Warren Buffet and elephant gun of practicall application.

I am not advocating for performance fees; just correcting the misconception of a linear application of investing based on fund size from the comments here.

Etienne:

What I mean with my second part comment is that a style fund would scale their strategy holdings with funds flow in and out by members. If your fund was $100m end Feb with 3.3% in Apple and in March you got another $10m then you would likely top up your Apple to stay at 3.3%

Obviously can be different with a closed or special purpose specific period product, but those have fees baked into the proposal.

If investing is a professional skill then it should IMO be rewarded like other professions. I don’t pay my dentist or lawyer based on my asset value :/

Anyway, not my problem. The professionals only touch a small RA that I was stupid enough to enter 30y ago. Everything else is DIY.

It’s never really about fees, performance etc. for Joe Average.

What AG, Franklin Templeton, Black Rock and the other heavyweights understand…

It’s 100% about marketing! That’s where your performance fee goes.

Oooo….DON’T bring that argument up in the Real Estate Agent industry! E.g. commission on a R8-million sale, will be 10X more than an R800K property sale. (if no discount is given)

Yet the amount of admin & legal work is NOT 10 times more.

But I suppose it’s true for many industries: is a R1,2mil car really 5 times better than say a R240K car? If a R240K car is able to reach 200kmh…does it mean the R1,2mil car should be able to reach 1,000kmh?? Or 5 times quieter or 5 times more luxurious? Off course not.
But higher profit ratios are made when you have wealthy(ier) customers… 😉 The wealthy earn their income easier, and spend it easier.

Michael:

Except that those rarified brain cells of the experts are applied once per portfolio for all the clients and all the runts in the mandate; not per million or billion or per client.

I suspect the model will change. Clients pay an administration fee (the account, the email statements, getting and allocating money, distributing income, etc) A grindrod bank account costs grindrod a few rands per month so I suspect an investment account with fewer issues than a bank account can’t be more.

Then the fund administrators pay professionals for fund allocation advice on a professional basis and those professsionals will get into value-based billing. No cure no pay – like you don’t pay the dentist if he/she pulled the wrong tooth.

I keep away from investment houses.

I make far, far more money doing it myself.

Really! So in your spare time you can outperform a fund manager with experienced portfolio managers and seasoned analysts. How?

Spark, you must’ve been lucky to’ve kept all your funds in Naspers the past few years *lol*

Very simple really. I invest in trending asset classes.

No fund manager ever wants you out of their funds. It’s a “long term investment so don’t get jittery in the short term” they say. Stay invested.

Well guess what.

It doesn’t work!

A bit touchy there Colson?

“There is also a growing body of evidence that the skill any asset manager possesses is only a tiny part of determining the return they are able to deliver.” Really!!!

Here is another take on passive vs. active investing http://buckinghamadvisor.com/passive-investing-without-indexes/

In which is explained that with the FAMA-French model there are about 5 factors at play. The two dominant factors that determine the risk and reward are large vs small cap; and growth vs. value.
Investors should really be making their choices along these lines.

Note the conclusion:

You don’t want to be like investors in actively managed funds, chasing returns. Instead, the choice of the fund you use should be based on other criteria, including what factors you want exposure to, how much exposure you want to those factors, the fund construction rules, for taxable accounts whether the fund is managed for tax efficiency and, of course, a fund’s expense ratio.

There is no correlation between fund performance and fees.

Performance fees are reasonable when there are equivalent underperfomance fees refunded to the client. Fund managers irrationally (despite their superior analytical skills) believe that a larger/smaller bonus (still charged to the client) is somehow symmetric.

Agreed – if the fund managers want skin in the game, they must be prepared to share the losses as well as the gains with the investor. As it stands they cannot lose and gain a lot.

People are challenging self-serving industry practices like high fees and performance fees, due to articles like this and other research from Morningstar, S&P. Investors are voting with their feet and fleeing companies with these poor practices. It does raise the question why some advisors still invest their clients in funds with these poor practices.

So true. As an industry fund managers fail ie after fees more than 50% cannot achieve the index. Allan Gray are really an old fashioned one sided crowd-high fees for bad performance, huge risks( look at the Emerging markets fund of Orbis -exposure to single shares is colossal) and if the risks pay off they charge even more.

Charge performance fees by all means if you beat the benchmark-but then drop the basic feesto what they are worth ie say 20 bps.

The industry is changing rapidly though-US fund vanguard has an SP 500 tracker that makes money out of script lending only ie ZERO fees

Why would you pay someone else to manage your money when you take the risk? Investing is not rocket science. If you are a short term investor wanting an above average return then visit a casino! It’s probablyless risky than giving it to a financial advisor who charges you and ends up putting your money into.steinhoff!

“funds that charge less will deliver higher returns” – total baloney! That’s a very broad UK/USA generalization and certainly not the case in the SA market, where the lowest cost funds are often also the poorest quality and delivering inferior net returns. There’s a reason why Allan Gray and Coronation are the most successful fund companies in SA over decades and if their fees are slightly higher then it’s fully warranted.

I guess we’ll never see any articles on all those index-tracker/ETF providers who claim to deliver an index return to investors but never have?

Wow what superior logic we have here. A performance fee can only be charged if a benchmark has been outperformed. If a benchmark is not outperformed then there is zero performance fee. So logically if EMPIRICAL evidence suggest that a performance fees causes the biggest drag on outperformance over time it is surely illogical. Logically, if these funds underperform it can only mean that the performance fee calculation or the benchmark used is wrong, not the principle of a performance fee. If memory serves, Allan Gray has changed their benchmark so now they charge performance fees if they manage to outperform the average performance of other asset managers….how pathetic have they not become in doing this. We all know the average manager underperform the index, so now they have stooped as low as the average manager, obviously a market index is too hard for them. As a client, I wrote an email to them in 2003 when they 1st started to advertise on TV that this to me signals that their clients have now become secondary of importance to them, high margin AUM it is. They have not disappointed me on my claim

Every Fundmanager set the bar so low that no extra effort is required to achieve the fee. Unless they really mess up they are pretty much guaranteed a performance fee. Funds with low fees will perform better in the long run

Show me just one fund with a benchmark that is inappropriate? Just one? Amazing, on the one hand people say only a tiny proportion of active fund managers can beat the benchmark indices and then in the next sentence the benchmarks are so easy to beat a performance fee is guaranteed. Seems like a huge chasm between some people’s view and reality.

Colson: it is getting really hard to compare a fund to a benchmark because does one use the benchmark at inception, or the 2005 one, or the 2010 one, or the 2017 one, etc etc etc?

The article also well enough explains that fees are charged during out performance years but not corrected for under performing decades.

Colson: how about the R40bn Allan Gray Equity Fund with the benchmark being the average performance of other funds in its category. It means they charge performance fees when they underperform the market. How is that a benchmark that is in the interest of their clients? I’m all ears

Johan_Buys: you also make no sense. If a fund outperformed an index in early and got paid a performance fee and then subsequently underperformed, its performance over the full period will still be better than if it just matched the benchmark in the beginning years and earned zero performance fees. So it is still better for their clients having paid the performance fees initially as it implies there was actaul outperformance. You do know that one cannot charge a performance fee in a way that the performance fee itself causes the fund to have a below benchmark performance, do you? So logically as a client the higher TER the better as it implies superior performance UNLESS your benchmark is rubbish and not actually the market like Allan Gray

According to the Feb factsheet for the Investec Value fund, although the fund is outperforming by 17.5% over 1 year, it is UNDERperforming its benchmark by 2.3% PER YEAR over 3 years and UNDERperforming by 1.9% PER YEAR over 5 years and yet I see they saw fit to charge 1.49% performance fees over the past year, taking the total expense ratio to 2.58%? This is highly unethical. Unless measured since inception, performance fees do NOTHING to align investors interest with managers.
ALSO Allan Gray measure their performance versus the category average. (conveniently changed from the All Share Index before!) So as long as they beat the AVERAGE manager (which includes every Joe Bloggs who’s set up a fund-of-funds etc, not just the direct asset managers) they earn a performance fee? And it’s not SINCE INCEPTION so they’ve earned hefty performance fees over time and have actually UNDERPERFORMED their benchmark over 10 years. On the Allan Gray Equity Fund, they are charging 0.8% additional performance fees over past year despite the fund being down 3%! (just less than the AVERAGE manager hence the performance fee)Daylight robbery.

Performance fees are like paying an employee a bonus – the employer/client should be the one to decide when or how much the bonus should be, not the other way around me thinks!

Performance fees are simply an excuse to milk clients. Can you imagine a situation where an asset manager thinks “I’m not getting performance fees for this fund, so let me not try so hard to perform well”?

On what planet do performance fees really incentivise an asset manager?

I am shocked to see these performance fees. No-one tells you or warns you about them. Thank you Patrick for this very educational article. We need lots more like this.

What a pathetic comment. Are you such a baby that you have to be told about the fees of a fund you want to place your hard-earned savings in? Why don’t you just read the fund literature, before investing, that is freely available on all the provider websites. That is what a reasonable person would do in my view. South Africans, get real and grow up.

Wow Colson, play the ball, not the man. At some stage, we all learn something for the first time. I’m not ashamed to admit when I don’t know something. Does calling me a baby for that make you more of a man? I doubt it. But hey, whatever blows your skirt up!

The point I was making was not that I never knew about performance fees at all, but that the research suggests that they are irrelevant and don’t work. I was grateful for this article by Patrick and was moved to express that.

So do you work at a company that charges performance fees? Are you SA’s top asset manager? What was your portfolio return over the past year? Five years? 10 Years? 50 years? How old are you anyway that you need to be so condescending to someone else?

Great response KaraboM! You’ve certainly earned my respect. Colson, you are exactly what is wrong with the industry.

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