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Performance arts

A growing problem is how to compare performance after fees. Total expense ratios have become a standard way of comparing funds on a cost basis and although there are flaws in the system, at least it provides some point of commonality.

Performance fees, which are not included in TERs, use a myriad of different models so it is difficult to determine what you are paying.

Such fees were once the sole remit of hedge funds and were used as payment for the added alpha that these vehicles aim to deliver. Performance fees on retail funds use the same justification. Their use on retail funds is more notable on more specialised portfolios, such as emerging markets or agriculture. That is not to say they are not present on mainstream equity funds as well and several investment trusts use performance fee models. However, the trend appears to be in adding such fees to more specialist vehicles.

This is one hugely growing area of the fund industry. The Investment Management Association’s specialist sector, which admittedly keeps taking in stragglers from other sectors, has 90 funds although only 37 feature track records of three years or more.

There is no denying the validity of the argument that you should pay extra for specialisation but determining what is being paid for such expertise is a point worth arguing.

It is no surprise that the use of performance fees is on the rise, considering what fund providers see as a shrinking margin on funds, having to split the annual management charge not only with advisers but also distribution platforms.

The seventh edition of Lipper’s benchmarking and performance fee study shows that 69.5 per cent of the 2,823 funds in its Europe-wide database now earn incentive fees. Total annual management fees from funds using such structures equated to around $5.7bn last year, with the performance element adding a further $2.9bn.

According to Lipper, its figures suggest that performance-related fees add 35.3 per cent to annual management revenue.

Adding a performance fee to existing funds can be difficult as it needs the approval of investors. However, launching a new fund offers a new stream of revenue for groups.

If a performance fee is not added, groups are tending to look at higher AMCs although in some cases a fund will feature both a higher annual charge and a performance fee, such as New Star’s Heart of Africa fund.

Lipper data shows that, of the 117 onshore funds launched in the past 12 months, 14 feature annual fees higher than 1.5 per cent, with the highest at 2.15 per cent. That does not seem particularly high but it is worth noting that the majority of those 14 funds are specialist funds. The exceptions to this are three European portfolios but even these use names aimed at emphasising their active nature – M&G European special situations, M&G strategic value and Neptune European max alpha.

Increases in annual fees have been seen for some years now, not only on new fund launches but also with restructures, and intermediaries say they are increasingly seeing fee amendments on funds coming through these days.

It is clear to see the advantages to fund groups but where is the advantage to the IFA in choosing funds for their client that feature such a structure? Unlike in the US, where the vast majority of performance fee structures use what is known as the fulcrum method, where the fee is reduced for underperformance, UK groups have rarely used such a model.

As the justification of performance fees is to align the interests of the fund manager with that of their investors, it is no surprise that a punitive pricing method is considered attractive from a buyer perspective. A few years ago, when the UK industry was examining the types of performance fees it could use, the IMA highlighted the myriad of options available to groups and among these was the fulcrum method. At the time it was being discussed, it was highlighted that many believed this to be the fairest approach.

Today, the investment fund market features numerous models and calculations of performance fees, with few punishing on the downside. In fact, many are based on relative outperformance, meaning that during this recent spate of negative returns by most funds, investors may be paying extra for the privilege of not falling as far as the index.

Models being used in the UK use any number of elements and combinations. For example, a high-water mark is a common component in most performance fees but just exactly how is it being used?

Of 1,326 funds examined by Lipper that had high-water marks, 102 reset their marks after a set period of time. Of those, eight funds do it after one quarter, 80 after one year, seven after two years and a further seven after three years.

There are still more variances and ones that are less technical that water marks. Some are based on relative outperformance but that could be the peer group average, a set benchmark, cash or absolute returns. Some performance fees are paid annually while others are based on the rebate of the AMC and the percentages levied can be anywhere from 3 to 30 per cent.

Working through what all this may mean and its impact on returns becomes very complex. Is the extra alpha supposedly generated worth the added costs or would another fund with fewer returns but cheaper fees return the same amount?

One way to create some transparency to what is becoming an increasingly murky area of fund management would be to adopt a life company measure and show a reduction in yield figure.

If these fees continue to gain popularity, justifying their presence will become a point of much scrutiny, particularly at times when the market disappoints, like now.


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