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How to evaluate performance fees

Questions to ask your fund manager.

JOHANNESBURG – When asset managers design performance fee structures, it is rarely a 50-50 game, an industry expert says.

Magda Wierzycka, chief executive officer of Sygnia, says when most asset managers set performance fees, they do it in such a way that the probability of achieving the objectives and levying the fee is skewed in their favour.

This can be done by setting the benchmark at a relatively low level – for instance by not having any hurdle above the benchmark, she says.

Even where performance fees are capped, the caps are usually set at levels that would only be triggered once the manager has outperformed the JSE All Share Index (Alsi) by 10% – something that is very unlikely to happen.

Wierzycka says performance fees can double, triple or even quadruple the amount of fees investors are paying.

Currently, products that charge performance fees can’t be used as tax-free savings accounts. These accounts are supposed to be efficient and transparent but because the performance fee can’t be determined upfront, it doesn’t meet National Treasury’s transparency benchmark, she says.

But in a landscape where fee structures are often opaque and difficult to dissect, what should investors keep in mind when evaluating performance fees outside of tax-free savings accounts?

Questions to ask

Wierzycka says investors need to ask how frequently the performance is calculated.

In many investment products performance is calculated on a rolling basis. This could mean that an investor will be paying a performance fee for performance he never enjoyed, she says.

Investors also need to find out what the asset manager’s level of participation is and whether the percentage is reasonable.

Ask whether the performance fee is calculated before or after the basic management fee has been deducted. In other words, ask if the outperformance is measured net of the basic management fee or gross thereof. There is a material difference, Wierzycka says.

Investors should also ask what the hurdle rate is. In other words, is the outperformance measured against a benchmark like the Alsi or against a percentage point (or more) above the Alsi.

Wierzycka says if there is no hurdle rate, investors should consider the manager’s past performance. If the benchmark is the Alsi, how likely is the manager to outperform this benchmark? How often has the manager managed to beat the benchmark in the past and if they did, how significant was the outperformance?

This will give investors a sense of what the performance fees could entail, she says.

With unit trusts, it is as simple as analysing the history of the manager’s total expense ratio (TER) over time. If the manager’s historical TER isn’t accessible through the website, ask the client service division for a spreadsheet.

“You are within your rights to ask. If someone doesn’t want to answer, is that really someone you want to do business with?”

It is also worthwhile to consider what the TER actually translates to in absolute (rand) terms. Fees expressed as a percentage are much less impactful, she says.

Wierzycka says investors should consider whether there is a cap on the performance fees and if this is really a meaningful number.

If a cap is applicable, ask whether it is applicable to the performance fee in isolation or whether it is applicable to the basic management fee and the performance fee collectively.

Also consider whether a high watermark principle is used. This means that the manager can never levy a performance fee on the same capital growth, Wierzycka says.

For example: If a manager delivers a return of 1% during the first year of an investment (R1 000 of capital growth for the investor), and charges a performance fee, any negative returns that follow (as well as the capital growth of R1 000) will have to be recovered before a performance fee can be levied again.

Wierzycka says investors should also consider the benchmark itself.

At the moment “the easiest benchmark in town” is CPI (the consumer price index), she says.

Inflation is expected to fall on the back of the lower oil price and as a result this target is quite easy to meet, she says.

Investors should also ask whether there is an alternative product available with a flat fee structure.

Wierzycka says typically a flat fee structure has a higher base management fee and no performance fee. The performance fee structure has a lower base management fee but a performance fee element attached to it.

In this instance the difference in the base management fee should be considered. In some cases the difference has shrunk considerably and it may be worth the investor’s while to pay a little bit more as a base management fee but to have the certainty and transparency of a flat fee structure.

Wierzycka says even where investors have limited knowledge of performance fee structures, it is important to compare the structures of different asset managers.

It is naive to argue that performance fees don’t matter because it is only triggered by outperformance. If 10% or 20% of the outperformance is forfeited in good times as a result of the manager’s performance fee, it could have a considerable impact over time, she says.

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Investment managers refuse to negotiate performance fees. Magda, what is your suggestion to negotiating that part of the initial contract?

Investment managers refuse to negotiate performance fees. Magda, what is your suggestion to negotiating that part of the initial contract?

If the fund-manager is unable to compete on grounds of performance, the only option is to compete on grounds of cost. To discount your skill is to admit non-performance. That said, cost is irrelevant if you compare performance after cost. Many times the most expensive fund-manager is the one with the lowest fee structure and an inflation plus 3% (or less) return.

It should always be simple as possible to understand. For our funds, we only use the high watermark principle as that is the fairest way, and on share portfolios the client can choose flat fee or performance fee, again using high watermark principle.
Did an analysis for a lady the other day, whose work pension fund charged 4.3% “advice” and administration fee, but it was invested in 1 fund (so no real advice there) and she then still has to pay the platform fee and the fund’s own fee, putting her paying around 6% fees annually. So if the fund does not do better than 12%, she is actually getting negative real returns.

Questions to Sygnia
Thank you for your questions. We will answer them as they appear.

Sygnia does not manage a Shariah compliant fund but it offers a couple of third party Shariah complaint funds on its LISP platform.

It is unfortunately true that active asset managers refuse to negotiate fees unless you are a R100m plus investor. In those cases we would suggest that you consider splitting your strategy between index-tracking strategies at low cost and actively managed funds which are a lot more expensive. That way you are at least reducing your average cost of your investment strategy.

Please can you provide the Total Expense Ratio (TER) during the period of 2013 & 2014 for the Sygnia Signature Fund of Hedge Funds, Sygnia Absolute Fund of Hedge Funds and Sygnia All Star Fund of Hedge Funds? (Including the base investment fee payable to the underlying Hedge Fund managers plus the performance fee paid to the underlying Hedge Fund managers and to Sygnia.)

Dear Barry. We are happy to provide all investment related information to legitimate investors who provide their name and contact details. Please contact our client service center for information relating to funds of hedge funds investments. Please note however that these products are not unit trusts and are not available to the man-in-the-street investor due to complexity. They also have very high minimum investment amounts.

Words can mean so many things. My method was to split the money between active and passive and look at the value after a period. That is how I got to move most into active and my choice of funds are delivering the goods year on year even if I have some of the highest TER funds with low benchmark and paying for the high return and lower risk.

Mutual funds never outperform the market, in fact with all the fees they probably only return halve of the return of the market over a long term. I rather invest in stocks directly. I use for ideas.

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