One of the arguments in favour of charging performance fees on unit trusts is that investors will pay more when they can afford to – when the returns they are seeing are good – and less when their returns are poor. In reality, however, it doesn’t always work out this way.
Because performance fees are generally levied based on the returns over at least a three-year period, there can be a lag. Even though a fund might be going through a poor period, it could still be charging for performance generated in a previous cycle.
“So in a year where you see significant underperformance, the fee is slow to adjust down,” explains Tamryn Lamb, head of retail distribution at Allan Gray. “And when clients see that negative performance, they might ask why is the fee still slow to adjust, and why is the manager not experiencing the pain with me.”
This creates a disconnect. The point of a performance fee is that it is supposed to reflect what the investor is receiving in terms of value for money. If the fee remains high when investors are not seeing returns, that can lead to a lot of unhappiness.
Allan Gray and Orbis have first-hand experience of this over the past year. In March Moneyweb highlighted how the Allan Gray-Orbis Optimal Fund of Funds had charged performance fees, despite its relative and absolute underperformance.
“If you’re really wanting to build client trust, we think you have to probably do your most work at the point when clients are feeling the pinch, at the weak part of the performance cycle,” says Lamb.
For this reason, Orbis has proposed a change to the fees on most of its funds available to African investors.
The change is intended to make the fee structure more ‘reactive’, so that the fee being charged will more accurately reflect an investor’s current experience.
“This is not something we are doing in reaction to the last year of underperformance,” says Lamb. “We think this is a better fee through the cycle.”
The main funds affected by the proposed changes are the Orbis Global Balanced Fund and the Orbis Global Equity Fund, which will also then reflect in the Allan Gray-Orbis Global Equity Feeder Fund.
The first component of the new fee is that it will be meaningfully lower when the fund performs in line with its benchmark. At this level the funds currently charge 1.5%. Under the new structure, they will charge 1.1%.
However, the potential for Orbis to earn additional fees for outperformance will be significantly greater. Currently, Orbis earns around 12% of outperformance as a fee. The proposal is to increase this to 25%. The total fee charged will also be uncapped – both to the downside and the upside.
The real innovation that Orbis is introducing is a refundable reserve fee mechanism. How this works is that clients will be charged based on performance, measured weekly.
This shortening of the measurement period is what will make the fee more reactive, as investors will be paying for what they are seeing at the time.
Each weekly fee is not, however, paid immediately to the manager. It is kept in a reserve pool. In times of underperformance, clients will be refunded from this pool. Orbis earns its performance fee from the reserve pool over the three years following any outperformance, provided that the outperformance is maintained and the fees do not need to be refunded to clients.
Although performance from one week to the next is as good as random, and has little to do with the fund manager’s skill, Allan Gray believes the cumulative effect of three years’ worth of one-week periods will essentially be the same if performance was measured over the three years as a whole.
“Refundable fees are unique in South Africa,” says Shaun Duddy, product development manager at Allan Gray. “We think they will help clients remain invested during periods of underperformance because it will be easier to see that our interests are aligned with theirs.”
The result of this, according to Allan Gray’s calculations, is that investors in these funds will pay more in times of extreme outperformance – where Orbis delivers returns of 7% or more above the benchmark.
At all other times, the fee will be lower than under the current structure, with the potential that fees could be negative in times of extreme underperformance, provided that there is money in the reserve pool. If there is no reserve, the flat fee of 1.1% will apply.
Pros and cons
There are both positives and negatives here for investors. On the negative side, the proposed changes make Orbis’s performance fee structure far more complicated. This is one of the greatest criticisms of performance fees, that they can be extremely difficult for investors to understand.
It’s also challenging to compare against the fees charged by other funds, since no one else is offering something similar. It is difficult to know whether this is a good structure or not until investors have actually experienced how it responds through performance cycles.
On the positive side, it is a genuine attempt by Orbis to improve its offering, and to lower fees at times when investors are seeing underperformance. Whatever one might think about performance fees, one can’t doubt Allan Gray’s conviction that they are the best way to align clients’ interests with their own.
“A big part of the problem that we are looking to solve is that at different points in time, we want clients to see a fee that makes sense to them relative to what they have experienced,” says Duddy. “We think the additional complexity is worth it when that materialises over time. Among other goals, we want to avoid situations where clients feel that they have experienced disappointing performance but the fee that they see on the fact sheet doesn’t resonate with that.”