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Performance art

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&#39s 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

below par.

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&#39s

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&#39s external fund links have broken new ground, with five of Britain&#39s

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&#39s 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.

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