Investment fees were catapulted back into the limelight last month after the City watchdog ruled that fund managers must simplify the way they charge customers.
But although the Financial Conduct Authority’s two-year probe into Britain’s £7trillion asset management industry resulted in it backing a new ‘all-in’ fee, the report largely sidestepped performance fees, paid to a manager when the fund beats its benchmark.
Instead of tackling these controversial charges this time around, the FCA promised instead to consult on their future.
Performance fee is and remains a contentious investment levy that can significantly add to the overall cost of the fund for investors
It was a contentious move, as while performance fees are typically levied on returns in excess of the benchmark the fund pits itself against – like the FTSE All Share – the sore point is that it seldom works the other way round.
Investors are not refunded for under-performance. So should you pay performance fees and is it worth it if you want to invest in a fund that charges them?
Performance fees can dwarf management fees so they’re an important cost to consider when choosing a fund.
The charge has historically been the preserve of hedge funds and exclusive to institutional investors but they have crept into the retail sector in recent times.
Typically, performance fees are levied on investment trusts and absolute return funds, the latter of which are built around a hedging strategy with the aim of generating positive performance regardless of market conditions.
They’ve come under the microscope for the umpteenth time following the FCA’s recent report, which said it will consider whether to apply more red tape on performance fees.
Daniel Godfrey, former boss at the trade association that represents asset managers – the Investment Association, has long argued for the demise of performance fees.
But Godfrey left the UK fund management trade body back in 2015 following a dispute with some of its biggest members over his plans to push forward consumer friendly initiatives including disclosing cost and charges.
‘Investment management without performance fees has high margins and high pay. Even without performance fees, there are two performance related benefits,’ he said.
‘Investment managers are professionals acting as your champion. They are well paid. I think most people would expect them to be competent and to do their best every day so why pay a performance fee on top?
‘A surgeon wouldn’t charge a basic fee for an operation and a performance fee for a better than average outcome.’
How are performance fees charged?
Performance fees are typically in the low double digits and are levied in addition the fixed management charges that go towards covering the costs associated with managing and operating an investment fund.
Some funds may include performance fees in their fund cost calculation so it is important to check the small print to find out what exactly you are paying for.
Performance fees also add an extra layer of complexity when it comes to fund comparison because it is difficult to predict when they will next kick in and there is a lack of standardisation in how they are levied.
Why are they charged?
Active managers are under growing pressure to prove their worth to investors who are increasingly opting for cheaper passive solutions that aim to replicate the performance of a chosen index such as the FTSE 100 at a fraction of the cost of active funds.
The idea is that a performance fee should motivate fund managers to generate higher returns for investors but there are question marks over whether they truly do this.
Research from Architas found that eight out of 10 funds that charge a performance fee have under-performed the MSCI World Index over the past three years
Critics of the charge argue that they could encourage managers to take more risk with investment money or invest for instant gratification to earn a bumper pay packet at the end of the year, rather than choosing investments that offer steady and sustainable growth over the long term.
Research from multi-manager investment company Architas found that of the 121 funds that charge performance fees and are accessible to ordinary investors, 97 them under-performed the MSCI World Index on a total return basis over a three-year investment horizon to the end August 2016.
Funds which levy a performance fee also have a total expense ratio (TER) almost 40 per cent higher than the average fund from the IA UK All Companies Sector (1.39 per cent versus 1 per cent).
Which funds charge performance fees?
Adrian Lowcock, of Architas, said the majority of funds charging retail investors performance fees are absolute return – those that aim to deliver positive returns in any market conditions.
But he added that while managers who charge a performance fee benefit when the their funds do well, they are not penalised for underperformance.
Lowcock said: ‘I think investors would have few complaints about paying a performance fee on a fund that beats its benchmark by a considerable margin time and time again so long as the fee is not too steep. But there are many good performing funds that do not charge a performance fee that investors can choose from instead.’
This view is echoed by Alan Miller, who co-founded investment management firm Spencer Churchill Miller to give customers low-cost options in 2009.
Before this however, he ran a number of funds at now defunct asset manager New Star including the New Star Hedge Fund which levied a performance fee.
Miller argues that performance fees should be banned within all retail funds targeted at the lay investor because they are simply too complex and investors do not realise just how much they can add to to the overall cost of the fund.
He added: ‘I recognise that if institutional investors want this type of structure, however, it is their choice as professional investors and they should be allowed to enter into such arrangements.’
Why are they so controversial?
Managers can charge a performance fee for very little performance at all if the hurdle rate of the chosen benchmark is low.
For example, some funds’ performance hurdle is three-month Libor which is around 0.30 per cent (as at 4 July 2017). If stating this, the vast majority of funds would beat the benchmark by a considerable amount.
But this is a cash benchmark so there is an argument for the performance of a fund to be measured against a benchmark that best represents the fund’s investment universe.
For example, it would make sense for the performance of a fund investing in UK blue-chips and small and medium sized enterprises to be measured against the FTSE All Share.
The FCA found in its interim report on the asset management market published in November last year that fund objectives are not always clear, and performance is not always reported against an appropriate benchmark.
According to experts, the City Financial Absolute Equity fund (previously City Financial UK Equity) is guilty of doing just this. The fund invests primarily in UK and global equities yet the fund’s benchmark has nothing to do with the performance of UK equities.
It is benchmarked against Libor which is currently a very low bar. Should the fund beat this, it deducts 20 per cent of the excess returns.
Some fund managers operate a symmetrical structure for performance fees where investors receive a refund for underperformance
The annual management fee on the fund offers no respite for investors. It levies 0.75 per cent which is around the industry average but is more expensive than other funds that charge a performance fee.
When asked to justify this, a spokesman said: ‘The City Financial Absolute Equity Fund is a fundamental long/short equity fund that seeks to achieve positive absolute returns over rolling 36-month periods. The fund has been a top quartile and decile performer over one, three and five years.
‘That said, we encourage investors who are considering an investment in either the City Financial Absolute Equity Fund or another fund in the IA Targeted Absolute Return sector to review and compare management and performance fees, but very importantly, to also consider other criteria including the performance in major UK equity market downturns.’
He added that the City Financial Absolute Equity fund has performed well in periods where UK equities have performed poorly which, he argued, demonstrated ‘very little’ correlation to the FTSE All Share index.
Miller said: ‘Managers can get a performance fee for doing nothing as it can be that the fee is charged on the gross performance – the returns before all fees. It is therefore possible for the fund to pay themselves a performance fee even when the end investor has made no money.’
Are there any plus points to performance fees?
Advocates of performance fees argue they align the interests of investors and managers and serve to attract the best portfolio managers.
They also point out that the levy applies only if investors make money, and in many cases, fund managers will not be given the bonus if they fail to beat the performance hurdle.
James de Sausmarez, director and head of investment trusts at Henderson Global Investors, said: ‘Performance fees have a role to play. Independent boards on trusts are keen on getting the best managers in to run the trust they sit on and performance fee is a way of attracting the industry’s best talent.’
The Henderson Smaller Companies Investment Trust, for example, levies a performance fee of 15 per cent but the firm applies a cap on the maximum amount an investor can pay in total management fees at 0.9 per cent in any one year.
It also charges a lower than average annual ongoing charge of 0.35 per cent.
de Sausmarez added: ‘Of course that does not mean that every form of performance charge is okay – they have to have the right characteristics to be justified. I think funds that charge a performance fee need to have a low base fee. So if these funds under-perform, managers won’t be awarded a performance fee and investors will pay a base fee that is lower than the market average.’
Some investment managers, including Orbis, do things a bit differently. It goes halves with investors when things go well – taking 50 per cent of any outperformance – but if the fund does not beat the benchmark, investors receive half the difference of under-performance back.
Ben Preston, an equity analyst at Orbis Investments, said: ‘We’ve always believed that we don’t deserve to succeed if we don’t add long-term value for our clients. That’s why we only charge a fee if we outperform in our UK retail funds and we invest alongside our clients.
‘It’s refreshing to see that the FCA’s report has left the door open for well-designed performance fee structures that create a true alignment of interests between managers and their clients.’
Should you invest in a fund that levies performance fees?
Neil Woodford’s Patient Capital fund does not have an annual charge but levies 15 per cent performance fee if it surpass the 10% hurdle
Some fund managers use a high watermark principle for calculating performance fees. Here, investors would only pay the performance fee if the fund’s net profit exceeds its previous highest account value.
This principle prevents investors from paying a performance fee on bumper returns that follow periods of under-performance.
One example is the Woodford Patient Capital fund, which does exactly this. In addition, the fund does not have an annual management fee but levies a 15 per cent performance fee only if it delivers a cumulative return of 10 per cent each year.
Sounds ambitious but Neil Woodford’s performance record gives him confidence that this can be achieved.
Equally City Financial could argue that it performs well despite the charges it levies on the City Financial Absolute Equity fund.
In fact It has the best performance over a five-year period -the recommended minimum investment time horizon- of any fund listed in the IA Targeted Absolute Return sector at around 132 per cent to 7 July 2017, according to FE Analytics data.