Many investors take a cursory look at the performance fee when investing in managed funds or Listed Investment Companies (LICs), perhaps figuring that a high fee is a good problem to have. It must mean the fund manager has delivered outstanding performance. It’s a reward for excellence, and we share the spoils together, right?
Not always. There is no market standard for performance fees, and it pays to know how a fund will reward its manager. The most common performance fee is 15 to 20% of the excess return above the benchmark plus the base management fee. Therefore, with an average base management fee for Australian equities of about 0.9% (which is paid regardless of performance), a performance fee often starts to accrue if the fund outperforms the benchmark plus 0.9%.
But it doesn’t always work like that. For example, there are Australian equity funds with performance fees calculated over the cash rates. In the last 12 months, the ASX200 is up 22%, while the cash rate is 2.5%. Even if the fund manager only achieves the index, a 20% performance fee will generate a payment of 20% X (22%-2.5%) which equals an eye-popping 3.9%, usually on top of a base management fee.
This reduces the index return from 22% to 18.1% less the management fee and expenses. That’s probably more than the investor is earning on the cash allocation elsewhere in the portfolio.
MySuper rules on performance fees
There have previously been no rules or guidelines issued by regulators on performance fees, so it was good to see some clarity from the Stronger Super Review. It’s a useful guide to what to look for, and many current fees breach this model. MySuper products are allowed to charge performance fees on the following terms:
- a reduced base fee that reflects the potential gains the investment manager receives from performance based fees, taking into account any fee cap
- measurement of performance on an after-tax (where possible) and after-costs basis
- an appropriate benchmark and hurdle for the asset class reflecting the risks of the actual investments
- an appropriate testing period
- provisions for the adjustment of the performance based fee to recoup any prior or subsequent underperformance (for example, high water marks, clawbacks, vesting arrangements and rolling testing periods).
Key findings from Morningstar study
In 2011, Morningstar studied 82 investment strategies in large cap Australian share funds, and found 18 employed some form of additional performance charge. They found that even the fund managers themselves often misunderstood their own fee calculations.
Their key findings have a significant overlap with the MySuper rules, plus:
- The headline performance fee is just one aspect which should be considered. The management fee has the potential to be much more costly.
- Absolute fee structures – those not linked to an appropriate equities-related benchmark – would have proven extremely costly to investors over the previous 10 years.
- Any performance hurdle employed should at least cover the base management fee, to avoid investors paying additional fees for potentially sub-par returns.
- Fund managers which have the ability to reset their high watermarks have the potential to act against investors’ best interests.
- Fund managers typically crystallise their performance fees over too short a period, creating the potential for a shorter-term mindset which is inconsistent with their stated longer-term goals.
High water marks
Performance fees should only be paid once the manager has recovered previous underperformance (either relative to an index or in absolute terms, depending on the incentive structure). This test in the performance fee calculation is called a ‘high water mark’ because the previous high level of the fund must be reached before the performance fee kicks in.
For example, assume the market index is up 10% in the first year, while a fund is up only 5%. Then in the second year, the index is up 10% again, and the fund rises a healthy 15%. Ideally, there should be no performance fee in the second year, because the manager has delivered index performance over two years (ignoring the impact of the base fee, which should make the hurdle for performance fees even higher). The high water mark established at the end of the first year needs to be recovered.
But here is an opportunity for a new investor which became highly attractive after many funds underperformed during the GFC. If an investor enters the fund in the second year in the above example, there will be no performance fee paid despite that investor experiencing an above-market 5% return. There is a negative accrual in the performance fee calculation from the year before. If the fund is one where the base fee is lower due to the performance fee, the investor can achieve active returns for modest fees if the timing is right. It should be possible to ask any fund manager for a list of funds with negative performance fee accruals.
However, this also demonstrates a weakness of pooled unit trust structures which Individually Managed Account-type products are designed to avoid. Performance fees in a unit trust must be calculated at the trust level as a whole, not by investor. The negative accrual from prior losses is shared with future investors in a pool, resulting in a return to paying performance fees earlier.
Vast variety of performance fees
Even within a single Product Disclosure Statement of a platform provider, the performance fee section shows amazing diversity, including non-compliance with the MySuper rules laid out above (and hence, these are not eligible to be My Super funds). Take as an example the PDS of Colonial First State’s FirstChoice Wholesale platform, available here (fee section on page 9). The variations include performance fees that are calculated:
- before management fees*
- after management fees*
- over zero – commonly used for hedge funds or ‘absolute return funds’ which do not have a market index (or beta) exposure
- over the cash rate
- over the bank bill rate
- over an equity market index such as the S&P/ASX300 Accumulation Index or MSCI World
- inclusive of franking credits and overseas withholding tax
- with a variation from 10% to a mouth-watering 25% of the ‘excess return’.
*An example of the difference is: assume a fund has a management fee of 1%, delivers 2% above its benchmark, and a performance fee of 20%. If the performance fee is calculated ‘before management fees’, it is 20% X 2% equals 0.40%. If it is ‘after management fees’, it is 20% X (2%-1%) or 0.20%. Easy to overlook, but costs an extra 0.20% in fees.
Performance fees make an extraordinary difference to the economics of running a funds management business. A rule of thumb is that a fund manager might expect the base management fees to cover the costs of opening the doors, while the performance fees deliver the profits, shared in large measure with staff. For example, the listed Australian company K2 Asset Management with around $750 million in funds under management had a good year in 2013, earning $24.3 million in performance fees compared with only $124,000 the year before.
Here are two examples of different approaches in the Listed Investment Company (LIC) space:
- Flagship Investments Limited is an Australian equity fund which aims to be at least 90% invested. Its performance fee is 15% of the amount by which its net performance (after all costs) exceeds the bank bill rate. On first look, this seems unreasonable, as a long-only equity fund is measuring itself against a cash index. But the mitigating feature is there is no fixed management fee, and the manager provides administrative services without charge. This approach pays off handsomely for the manager in good equity market, then he relies on his own resources in flat or down years. An investor can decide if this is fair.
- Sandon Capital is a new Australian equity LIC currently in the IPO stage. Its performance fee will be 20% above the one month bank bill rate, plus a base fee of 1.25% per annum. Again, on first blush, it looks expensive. However, this is not a normal long-only fund, it is an activist fund. It will invest in shares where the manager will advocate for change to unlock value, and may often be substantially in cash. Again, the investor can decide if this is fair.
These two funds illustrate the unique circumstances behind many performance fees.
In summary, the ideal performance fees will be measured against an appropriate benchmark after allowing for the fixed management fee, be subject to a high water mark and have some trade off with a lower base fee. But there may be particular circumstances related to the way money is managed which justify a deviation from this formula.