Paying performance-related fees may seem the perfect answer to motivating
fund managers. If they perform well, they earn more. If they do badly, they
earn less or even nothing.
Unfortunately, nothing in life is that simple, which is why
performance-related fees are not generally used in retail funds. The place
where they are notoriously employed is, of course, the derivatives and
hedge fund markets.
The problem here is that spectacular short-term gains can lead to massive
performance fees. Sometimes, the client is left with just a fixed return.
These gains are invariably followed by losses, for which there is no
compensation for the client.
There is also the problem of risk. Is the fund manager taking unacceptable
levels of risk in order to generate the performance fee? The other end of
the scale is almost as bad. A fund manager is hardly likely to pay much
attention to a portfolio on which they are earning nothing.
However, NPI has recently appointed external investment managers and
created a formula that looks set to work very well. The two fundamental
elements of control employed are the benchmarks set for risk and
performance. The managers are thus constrained to operate within the
requirements of the pension company but have the incentive to produce
higher than average performance.
The risk benchmark is the Lipper portfolio benchmark, which applies to
each type of managed fund. Lipper, a Reuters-owned analyst, determines the
benchmark by analysing the portfolios of all the funds in, say, the
balanced managed sector. The composite portfolio becomes the benchmark for
that sector. NPI's external managers can be up to 15 per cent overweight or
underweight in any one investment area.
The pie charts below show the benchmark weightings for balanced managed
and stockmarket managed funds. The latter has a greater proportion of
equities and, in particular, foreign equities which give a higher risk
profile. The external fund managers are therefore constrained in the amount
of risk they can take.
The second benchmark is for performance. The performance benchmark is set
at the 40th percentile level, which means first- and second-quartile
performance is considered good and third-and fourth-quartile performance
The table above shows the range of investment performance produced by
funds in the balanced managed and stockmarket managed categories over one
year. The first-quartile stockmarket managed funds produced growth of
between 28 and 65 per cent while the fourth-quartile funds produced only 2
to 12 per cent.
Similarly, for the balanced managed category, growth in the first quartile
was between 17 and 45 per cent while, in the fourth quartile, performance
ranged from -2 to 9 per cent.
This demonstrates the wide range of investment performance which is
possible within the benchmark guidelines.
The other element of control is the fee scale, which is capped at both
ends and runs from 0.25 to 0.75 per cent. So, for consistent performance,
the manager would get:
First quartile: 0.75 per cent.
Second quartile: 0.5 per cent.
Third quartile: 0.4 per cent.
Fourth quartile: 25 per cent.
At the benchmark level, the additional annual management charge on NPI's
externally managed funds would be a very reasonable 0.5 per cent. At the
top end, the charge is more than a manager would normally get for
institutional business and at the bottom end there is still enough to keep
working for an improvement.
NPI's external fund links have broken new ground, with five of Britain's
leading fund managers agreeing to the same performance-related scale.
However, there is more to choosing external fund managers than getting them
to agree a fee scale.
First, they must have a good and consistent long-term record. Second, they
must have a well-known name and a good reputation among advisers. Third,
they must have a sound investment process and the strength and depth to
cover every eventuality.
This seems like a pretty tall order but NPI's selection process whittled
the first 40 candidates down to five – Baring, Newton, Perpetual, Schroder
and Societe Generale. Each has its own investment style, which is important
when it comes to spreading investment risk, and each has agreed to work on
the same performance-related basis.
There seems to be no reason why it should not work and we can expect to
see many similar arrangements emerging as time goes on.