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December 15, 2022

When performance fees punish

Six nasty hidden pitfalls that hammer your investments

Performance fees are becoming an increasingly popular method of charging among asset managers—but there are nasty hidden pitfalls in calculations that can cost investors dearly.

A growing number of asset management companies are turning to performance fees as an alternative to fees as a percentage of assets under management.  The latter can be a lucrative and easy way for investment professionals to make loads of money for doing very little to outpace the market.

While 2% of an investment may seem like a small figure to pay for the services of a financial expert with a string of degrees behind their name, it becomes particularly sumptuous as the amount of assets under management increases.

As an example: a 2% fee on R1 million is R20 000, while a 2% fee on R10 million is R200 000.  The fee becomes bigger and bigger as assets under management grow, although the percentage stays the same.  Paul Stewart, deputy managing director of Plexus Asset Management, says that generally the amount of work doesn’t increase proportionately along with the size of assets under management.

Fixed costs can become a pricey way of paying for asset management if you have a large sum available for investment.  They can encourage an asset manager to become an ‘asset gatherer’ rather than concentrating on investment performance.

That said, there is some incentive for the asset manager to perform even if they are an asset gatherer, because better performance bolsters the size of a portfolio and attracts more cash for management—but many believe there is an even better way to squeeze extra performance out of an asset manager: through performance fees.

These are an increasingly popular marketing tool designed to appeal to investors who want to align the asset manager’s interests and risk profile with theirs.  The theory is that the manager shares in your returns when they ensure that the fund does better than the agreed investment hurdle (or benchmark), and gets less when not on top form.

Ideally, the performance fee should be an alternative to the fixed fee.  However, performance fees come in many different guises—not all of them good.

In certain situations, performance fees have a very sharp bite—to the detriment of investors, and to the benefit of the asset managers.  Although the unit trust industry is associated with greater transparency than other investment areas, nifty financial tweaks and omissions around performance fees can cloak the real impact of these costs.

Association of Collective Investments chief executive Di Turpin noted that the organisation can’t regulate the use of performance fees; however, there are standardised terms for disclosure.  This “facilitates comparison”, she says.  You can find these on unit trust company websites.

Here are some areas you need to watch out for:

Benchmarks that are too low

The easiest way to increase a performance fee is to lower the hurdle or benchmark.  One example is where a cash return for an equity fund would have been a very easy benchmark in good years where the stock market produces double-digit performance.

Benchmarks that are zero

One high profile fund manager, who does not wish to be named, noted that some investment managers reward themselves for any performance above zero (0%).  That means they consider any gain (regardless of whether it matches or exceeds inflation) as acceptable performance—but you could be losing money in real terms.

This practice of zero percent benchmarks is often used by hedge fund managers, said the source.

Benchmarks that reward market performance, not fund manager performance

Are you paying for the fund manager’s skill (alpha) to produce returns that are better than the market or competitors?   Or are you paying for the return you can expect the market to achieve (beta)?  If the performance target matches (or is close to) an index, know that you are paying mostly for beta, says Stewart.

Performance figures that are not net of performance fees

Be wary before you invest in that fund.  Stewart has seen performance fees adjust returns to the extent that a fund can dive from the top of a performance table to the bottom of the second quartile.  This was however not a unit trust fund, as these disclose performance net of performance fees.

Performance fees based on rosy past returns

These calculations use past performance (rolling periods) to deduct fees.  The trouble comes when you enter a period of poorer performance, because fees are charged on the basis of superior performance over the prior period.  This means that you pay high fees at a time when your investment performance is down.

The fee can take months and even years to ‘realise’ that the performance of a fund has dropped off, says Johan Schreuder, a product expert at Investec Asset Management.

Performance fees that don’t punish the manager for underperformance

Symmetrical fees, or those that reward fund managers for good performance and take fees away when times are bad, are the most fair for investors.

Some fund managers keep an account for holding performance fees, so that the investor can ‘claw back’ fees during periods of relative underperformance.  This softens the blow of poorer returns.

Depending on when you enter a fund, you can share the ‘claw back’ fees.

Schreuder notes that basing fees on cumulative performance—or paying for today’s performance today—is generally the fairer method.  However, when performance is poor and fund managers are giving back fees, new members who never paid fees when performance was good can benefit from the practice.  “The fees can be shared between individuals, so they can be less fair on investors who have been in a fund for longer,” he says.

Some industry watchers believe that there is a case for some regulation, particularly as many advisers are not aware of all the nuances involved in performance fees.

Performance fees—and you will find them associated with various funds, not just unit trusts—help create the veneer that the fund manager has the investor’s best interests at heart.  Don’t fall for the spin.  Analyse when you are likely to win or lose before agreeing to a certain type of performance fee.

Published in Personal Finance Issue 317 (June 2007).

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.  Errors and omissions excepted (E&OE)

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