Ever since certain unit trusts introduced performance fees we have had numerous discussions in our office about their desirability.
I can categorically state this has never ended other than with a unanimous belief and conviction that performance fees only benefit the fund management groups. They do not benefit the client, indeed, the client is normally disadvantaged by them.
We have heard all the arguments – “Are you not prepared to pay for truly excellent fund management?” or “We need to have a better fee to compensate for having a small fund.” One fund is £2bn in size.
The crux of the matter is that performance fees are only designed to benefit the fund manager. This is countered by the bland contention “only when he performs”.
I suppose that some funds with performance fees have slightly lower annual management charges which means if the manager does not perform they are only left with the annual management charge but in general there is no penalty for lack of performance.
At this point, I must relate a poignant story of performance fees.
A few years ago, a man advertised he was going to walk across a tightrope above Niagara Falls pushing a wheelbarrow.
He employed an agent to sort it all out for him and the agent was going to be paid a performance fee based on the number of people he managed to persuade to pay $10 a ticket to watch. However, the agent found it difficult to sell tickets on the basis that the tightrope walker might not perform in inclement weather so the tickets were sold on the basis of no walk, no charge.
The day arrived and everyone waited expectantly. The tightrope walker suddenly noticed storm clouds on the horizon. A quick consultation with both the Canadian and American meteorological offices confirmed the storms were heading their way.
The tightrope walker refused to walk on the basis that if the storm should arrive he would not survive. The agent, concerned about the loss of his fee, pleaded with the tightrope walker and told him that the storm clouds would not arrive until after he had finished.
In the end, the tightrope walker turned round and said to his agent: “You are absolutely sure it’s safe then are you?”. The agent nodded in affirmation.
“OK, I will do it” said the tightrope walker, looked back at his agent and said “hop in the wheelbarrow.”
The point I am making is that the agent had no downside. Indeed, if the tightrope walker lost his life, the agent would still pick up his share of the gate money.
This is an identical situation with all performance fees. The fund manager benefits when he performs but has no downside if he underperforms.
I firmly believe that if fund managers insist on performance fees “for superior investment management” failure to deliver the superior investment performance should result in the reverse of how they would benefit if they deliver.
Surely, it is only equitable for a performance fee to exist if the benefits to the fund manager on the upside equally disadvantage him on the downside. He should put the money in.
There is an even greater worry in the direction of performance fees. There are two types of performance fee which we totally abhor.
The first one is obvious. Quite simply, a performance fee with a hurdle rate that is no hurdle at all. For instance, several unit trusts have a performance hurdle to beat Libor which is currently at 0.73 per cent one month, 0.57 per cent three months.
The other hurdle rate which is not quite so obvious is a hurdle which is based on a short period. In other words, if the fund outperforms for three months, the fund manager can take his money out after three months.
If you look at how markets move, there is every chance that, over a short period of time, he will outperform whereas he should only benefit over a long period of time or the money will go from the fund and there will be less money in the fund to achieve results for the client.
In conclusion, if we are recommending investment funds to our clients we should be exceptionally vigilant with regard to performance fees.
A good starting point is to boycott all funds with performance fees. I suspect there are fewer than a dozen investment managers in this country that really warrant them.
However, if that is really the case, then the performance fee that they bolt into their remuneration package should be completely equitable and if they do not deliver it should hurt to the extent that they do not get paid at all. In other words, at the very minimum, they should lose a static charge.