Should you pay performance fees when returns are negative?

The answer might surprise you.

JOHANNESBURG – When performance fees were initially introduced, it was perceived as a way to align the asset manager’s interest with that of the investor.

But almost two decades later a growing number of commentators – including National Treasury – are asking whether performance fees have been successful in achieving this objective.

“There is little evidence that the implementation of performance fees has actually resulted in improved performance,” says Marelize Smit, head of quantitative analysis at Sygnia.

If a manager were to admit that his investment methodology differs depending on whether performance fees are charged or not, it would be a “serious red flag” as it would suggest that the manager was putting his interest ahead of the client’s, she says.

Some commentators believe performance fee structures are too complex for the average investor to understand and that it is difficult to compare products across different managers (fee disclosure practices aren’t standardised).

There is also a possibility that investors could pay performance fees, even during periods of negative performance (i.e. in cases where the market value of the investment reduced).

She says because performance fees are calculated relative to a benchmark, there could be instances where the benchmark lost 10% during a particular period, and because the manager was able to limit his losses to 5%, he would still be able to charge a performance fee because he outperformed the benchmark even though the investor lost ground.

Should investors pay performance fees when returns are negative?

At first glance, the answer to this question should be a simple, logical “no”, but unfortunately the issue is much more complex, Smit says.

Investors find some comfort in paying fees when returns are good and generally this is not an issue, but what investors have to consider are the overall fees paid throughout the investment cycle.

“The moment you take that holistic view, the question is not so straightforward anymore,” she says.

One way of ensuring that investors don’t pay performance fees is to choose a benchmark that would almost guarantee that the investor would not pay a fee during periods of negative performance. If the benchmark was CPI plus 7%, consumer price inflation would need to be more than -7% before the benchmark would move below zero.

“If your fund ever has a negative return it can’t outperform the benchmark, which will likely always be positive. So that is one way of ensuring that you don’t pay fees when performance is negative,” she says.

But during periods of positive performance, it might be so easy to outperform the same benchmark that the fees the investor will end up paying during those periods would completely outweigh the fees he or she would not be paying during periods of negative performance.

Choosing a benchmark that is more suitable to the fund strategy as opposed to an unrelated benchmark (like a CPI-based benchmark) will likely lead to lower overall fees during a full investment cycle, she says.

What investors should consider

Smit says investors should really try and be aware of all charges and fees imposed by the asset manager – performance fees are just one component of the overall fee structure.

With regard to performance fees specifically, investors should attempt to understand the calculation methodology and how the various components might impact them.

Smit says investors should ask whether the benchmark used in the performance calculation is relevant and appropriate and whether the bar isn’t set so low that performance fees would almost be levied automatically.

Another important question investors could ask is whether there is a hurdle rate. A hurdle rate would typically increase the benchmark and lower the odds of outperformance and performance fees being charged, she says.

Investors also need to consider the period used to measure outperformance.

The longer the investment period, the more likely the outperformance will be related to the manager’s skill as opposed to general market volatility.

That being said, investors should also keep in mind that if a performance fee is charged based on the performance over the last three years, and the investor only joined the fund a year ago, it might not be fair to pay a performance fee for returns in which he or she could not participate.

Smit says investors also need to ask if the asset manager uses a high watermark – which will be to investors’ benefit.

The high watermark principle prevents the manager from charging performance fees for the same performance twice. In other words, if performance fees were charged up to a particular level of outperformance, any subsequent underperformance first has to be recovered before performance fees can be charged again.

With regard to caps, investors have to consider how likely it is that the cap will be reached.

“If the cap is set too high, it basically doesn’t have any impact because the fee might never actually reach the cap.”

Smit says investors should also look at the base fee charged. The base fee is supposed to be lower where funds charge a performance fee, but that might not always be the case.

When the outperformance is calculated, it should be done net of management and base fees. Although it will be a difficult exercise, investors should also try and compare structures across different managers, she says.

* This content was sponsored by Sygnia.



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These performance fees are only complex because the U/T companies make them complex – they probably sit with a room full of actuaries who do nothing but muddy the water. In the long run it is better to do your own investing in stock markets as you get to keep all your performance fees for yourself – so read and learn and invest outside of U/T’s


I echo your sentiments completely, offshore equities aside, most investment houses invest in a handful of the same, ‘usual suspects’ companies, by opening a direct share trading account, then going on to all their websites and downloading their fund fact sheets, you can do as they do, (am exaggerating, it’s not as easy as that, but you get the picture) and save yourself an incredible sum of money, but the average investor is just not sophisticated enough as yet.

That said, let me ask this:
At what point do you put your hands up, take a bow, and say: You know what Mr/Mrs Fund Manager, you’ve done a great job, and as a reward, and as an incentive for you to keep this performance up, you can have a performance fee ?
Is that at CPI+5 or 6 or 7 or 10 maybe ?
What benchmark should investor’s use ?
I’d love a article on this, and this alone.

It cannot be that the active management industry continues to be vilified for performance fees as a whole, when it is clear that others do their job better than others.

I fully agree your sentiments, but unfortunately the industry set the rod for their backs years ago when they thought they would be clever and set bench marks and performance bonus criteria.
In the company I worked for you were rewarded and incentivised through doing you job (for which you were employed) accurately, on time and within budget. This was a totally internal reward system, why U/T’s have moved to a reward system which is external in terms of setting bonus and stepping these bonuses is beyond me. To my mind bonuses should be paid on the basis of growth in the wealth of the customer over 1, 5 and 10 years – to stop the “one hit wonders”. The bonus could also be in the form of awarding units in the trust and that they are only encashable after 3, 4 and 5 years after being awarded. Also no real growth above inflation and costs – then no bonus units are awarded

A good place to start, in my humble opinion, is how all investment fund managers report past results. Use the KISS principle, which can be understood by anyone with simple logic. They must all tell me for every R100 that comes out of my bank account how much money will land back in my account after one year (excluding my personal bank charges of course). That way there is no need to study, interpret and extrapolate what the return will be, based on their complex formulas with multiple lines of fine print. Why do I need to “study for a financial degree” in order to make a simple comparison of which fund performed better. I don’t care what they call their fees / charges / expenses etc. Take what you feel belongs to you and simply let me know how much I get in return (net). My return then has to be simply split between capital and revenue. Do I need to know any more? Don’t think so. Thank you very much. Why can this not be done? Anyone at the FSB? Can Moneyweb ask this question? Seems it has to be complicated so that Financial Advisors (and maybe journos) are kept in business.

Have a look at the poor long term Orbis performance compared to their extravagant fees. This applies to a lesser degree to the local Allan Gray fees. I suspect people will start complaining about both poor performance as well as their fees. But I think they will ignore complaints and keep on charging despite the poor long term performance. The same probably applies to other fund managers so best to think about the Vanguard route or something like the UK Fundsmith fund. The fees their are more in keeping with results.

When it comes to offshore I have paid school fees on the high fees (Orbis, Glacier and others) and decided no more. I have now switched to Vanguard ETF funds which charge around 0.1% p.a. I access these through FNB Securities (other banks also offer), via Saxo’s global trading platform. Low brokerage, low fees, money offshore, better long term returns (due to fee savings). Set up a bit of a pain, but well worth the effort for long term investors.

Yes, Orbis has probably cost many South Africans plenty of school fees. Quite why we all, or so many of us, so blindly paid so much for not very much in return is beyond me. Must be brilliant marketing by Allan Gray.

Performance fees amount to being charged twice for performance since annual management fees, being charged as a percentage of a portfolio, will automatically increase with better performance anyway.

If your objective was to lose money, you should pay. On the other hand, the answer is very clear, you should not pay anyone to lose you money, I mean that is absurd. Just throw it down the drain yourself, without anybody’s help, or give it to charity, where it might have a significantly high social return. Why would you pay anyone for under performing? Really? C’ mon now!!!

stay away from Allan Gray- they have cost u ton in returns for avoiding listed prop.But they charge you 2.5% for that f up.Arrogant Aholes.

It is my view that Allan Gray cost its clients more than R 20 billion via its 25 % stake in the old Western Areas, when in 2006 they voted (on behalf of its clients, naturally) for the booting of independant directors Blersch and Dale, and announced that there is no doubt that JCI voted its R&E shares in the same direction. They also said that they believe that R&E shareholders “will enjoy the best chance of a fair and speedy settlement with JCI under their directorship”.

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