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.