By Annika Bradley and John Nunan 7 Apr 2016

The low down on managed fund fees and costs (Part 2): performance fees

Performance fees can align a manager and an investor, but the devil is in the detail. Annika Bradley and John Nunan explain how they work and what to look out for.

Snapshot

  • Performance fees can be charged for beating an index, beating an absolute number or a combination
  • Check for mechanisms like a high water mark to ensure underperformance is recouped before a fee is payable
  • Assess the merits of a performance fee in the context of the total fee charged

In The low down on managed fund fees and costs (Part 1): base fees we explained that there are several components of ‘investment fees’ and that understanding their nuances and being able to compare apples with apples is key to good decision making.

In the first article we looked at base fees across the different types of managed funds. Now we’ll take a look at performance fees and how they work.

What is a performance fee?

As the name suggests, a performance fee is based on the performance of the manager and is supposed to align the interests of the manager and investors. It’s good in theory, but the devil is in the detail.

Defining how ‘well’ a manager has performed is typically done using a hurdle rate – the return the manager has to beat before the fee is payable. Performance fee hurdles come in many forms – a manager may be rewarded for beating the return of an index, an absolute number or an amount based on some combination of the two (typically the manager has to beat the higher rate).

The basic premise is that the manager needs to generate performance in excess of the hurdle and they then share in the spoils with you. That is, you get 100 per cent of the performance (after base fees) up to the hurdle rate, and then pay the manager some of the performance they have generated over this rate. In theory, the more difficult the hurdle the better for the investor, but note that setting hurdles too high might encourage the manager to take excessive risk in order to have a shot at earning a performance fee.

Table 1 contains examples of hurdle rates used by some well-known managed funds, with each hurdle based on an index relevant to the asset class the manager is investing in. For example, Celeste are trying to beat a small cap indexThe colloquial name for the S&P/ASX Small Ordinaries Index, a speciality index which reflects the performance of those companies in the ASX 300 index, but outside the ASX 100 index. (as they are a small cap manager), not one of the large cap indices. The benchmarks listed are also ‘total return’ or ‘accumulation’ indices – meaning each index includes returns from share price movements and dividends paid.

Some indices are ‘price only’ and do not include returns from dividends (worth around 3 per cent a year historically for international equities). Using a price index makes the hurdle rate a fair bit lower and easier for the manager to beat. In our view using price indices as a hurdle rate is inappropriate, but it has been done, so keep an eye out.

There are pros and cons with each hurdle. An index hurdle can result in you paying a performance fee when the fund has lost money but has outperformed an index that has fallen by more. Psychologically, this can be difficult for investors to accept in falling markets and it is something to prepare yourself for in the event you choose a fund with this sort of performance fee structure.

On the other hand an absolute return or cash rate hurdle can be simply too low, or see the manager earn a performance fee because they’re riding a strongly performing market (not outperforming it). For example, if you are invested in a share fund, you’d typically expect the fund to generate returns far in excess of a cash return even if it doesn’t outperform the relevant share index.

There are pros and cons with each hurdle. An index hurdle can result in you paying a performance fee when the fund has lost money but has outperformed an index that has fallen by more. Psychologically, this can be difficult for investors to accept in falling markets and it is something to prepare yourself for in the event you choose a fund with this sort of performance fee structure.

The idea of combining absolute and relative return hurdles is to make sure the manager both makes money and outperforms the market generally. For this reason, the hurdle is typically defined as being the higher of the absolute or relative return figure (for example, see the hurdle definition for Magellan Global Fund in Table 1).

There are also other ways that hurdles can be made more challenging, with the most common technique a ‘high water markCalculations of the performance fees payable to the managers of funds often include a 'high water mark'. Effectively this is a requirement that the fund recoup any past losses in calculating the profits on which the performance fee is based.’ mechanism. A high water markCalculations of the performance fees payable to the managers of funds often include a 'high water mark'. Effectively this is a requirement that the fund recoup any past losses in calculating the profits on which the performance fee is based. requires that the manager recoup any underperformance (compared to the hurdle) from prior periods before a performance fee can be paid. This mechanism is critical for maximising the alignment of interest between manager and investor.

A performance fee ‘free kick’ for the investor

One thing to keep an eye on when investing in a managed fund is a situation where the manager has underperformed their benchmark for a period of time. If this is the case (and assuming they are subject to a high water markCalculations of the performance fees payable to the managers of funds often include a 'high water mark'. Effectively this is a requirement that the fund recoup any past losses in calculating the profits on which the performance fee is based. hurdle), you will enter the fund at a time when they need to catch back up to their high water markCalculations of the performance fees payable to the managers of funds often include a 'high water mark'. Effectively this is a requirement that the fund recoup any past losses in calculating the profits on which the performance fee is based. before they can be paid a performance fee.

As a result, you get a free kick – you get the benefit of the high water markCalculations of the performance fees payable to the managers of funds often include a 'high water mark'. Effectively this is a requirement that the fund recoup any past losses in calculating the profits on which the performance fee is based. without having experienced the prior underperformance – and you’ll pay lower overall performance fees than when investing in an identical new fund, or one which hasn’t had a prior period of underperformance.

The timing of performance fees is also worth paying attention to. From an investor’s perspective the less frequent the payment the better and from a manager’s perspective the more frequent the better. A less frequent payment means the manager has to beat the hurdle for a longer time period.

Ideally the frequency of payment of a performance fee would align with your investment horizon – for example, for a share fund, 5 to 10 years. However, in practice it doesn’t work that way. Most funds investing in liquid, listed investments pay performance fees on a quarterly to annual basis. However if you invest in a direct property, infrastructure or private equity fund (funds that invest in unlisted assets) often a performance fee is not paid until the underlying asset has been sold.

A final consideration, for funds that invest in a single asset class, is how the presence of a performance fee impacts the base fee. Many managers with performance fees have lower base fees than peers with a base fee only structure, so it’s important not to consider base fees or performance fees in isolation. If a manager charges both types of fees, you need to consider what the total fee load is likely to be and whether this is reasonable.

You will need to read the PDS carefully though – in the case of the AMP Global Listed Infrastructure Securities Fund the performance fee component was buried in the ‘Incorporated Information’ (a supplementary document to the PDS) and the performance fee estimate was conveniently based on a period where the fund hadn't earned a performance fee resulting in an estimated performance fee of zero.

Diversified (multi-asset class) funds

Until now we’ve focused on the issues for single asset class funds (for example, Australian or international share funds). However, some peculiar consequences can arise with diversified (multi-asset) funds investing across a range of asset classes and managers – each with their own performance fee.

Your diversified fund may experience a negative return – both absolute and relative – yet still pay performance fees to some of the underlying managers. How can this be? Often, each underlying portfolio in a diversified fund is treated in isolation (for performance fee calculations) and if some have done well and some have done badly, the results do not net off.

However, it is difficult to know what you’ve actually paid, to who and why. Performance fees charged by underlying managers are often buried in ‘indirect fees’ in the fine print on an historical basis (that is, performance from a few years ago). Indirect fees disclosed seldom distinguish between an underlying manager base fee or performance fee. For example, Perpetual Diversified Real Return Fund charges 1.13 per cent of base fees and then the PDS discloses there is an additional 0.11 per cent of ‘indirect costs’ which include ‘any performance fees charged in downstream underlying funds’ for the year ended 30 June 2014.

Schroder Real Return CPI Plus 5% Fund on the other hand is invested in fee free underlying Schroder funds and you just get charged the one top-line base fee of 0.90 per cent and no performance fees or ‘indirect costs’ (either base or performance) – it’s much easier to understand.

The impact of performance fees on your return

If a manager performs well over a given period, be prepared for what could amount to a pretty hefty performance fee. To illustrate with a basic example, say your manager beats the index by 5 per cent and they take 20 per cent of the return above the index, you are looking down the barrel of paying away 1 per cent of the 5 per cent in outperformance. Frankly, if the manager is skilled enough to generate this sort of outperformance consistently, you should be happy to pay. But it still reduces the amount in the investor’s pocket and if you find two managers with similar skill levels but only one charges a performance fee, then (assuming base fees are the same) it should be an easy choice to pick the manager without the performance fee.

The trick is always to look at the fee structure holistically and in the context of the asset class. For example, Flagship Investments Limited’s performance fee structure of 15 per cent above the bank bill rate for Australian equities looks like a pretty easy fee to earn (particularly in a raging bull market) but there are no base fees charged.

Celeste Australian Small Companies Fund is a good example of where we accept the performance fees charged as there are very few small cap managers who don’t charge a performance fee.

If you have questions about the performance fee structure for a particular fund please let us know via the Q&A function. And keep an eye out for Part 3 of ‘The low down on managed fund fees and costs’ where we look at transaction costs and bring it all together.

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