Performance anxiety: do your fees reflect your desires?

Over the last number of years investors have grown more sensitive to the fees that they pay fund managers. Particularly in a low return environment, they are looking for lower fee options that don’t eat into their growth.

Performance fees have come under particular scrutiny, as investors are asking more questions about whether they really make sense. And the growing consensus seems to be that performance fees benefit the fund manager far more than the investor.

Figures produced by fund research house Morningstar certainly seem to back this up. The table below illustrates the current performance fee environment in five major local unit trust categories:

Source: Morningstar

*TER: Total Expense Ratio

What stands out most about this table is that across all categories, funds that charge performance fees are more expensive than those that don’t. There may be individual exceptions, but as a general rule, a performance fee results in a higher cost to the investor.

This is also at a time when performance is not particularly outstanding. Returns have been low, and in some cases negative.

The general equity category stands out in this regard. Despite charging an average TER of 0.60% more, funds with performance fees delivered an average return that was not only negative, but was worse than their peers who don’t charge performance fees.

Under the circumstances, one has to ask what it is they are charging for. On what basis could this be justified?

Those fund managers who charge performance fees argue that they align the interests of the fund manager and investors. This is because fees will be higher at times when investors are seeing better returns and lower when performance is muted. So investors pay what they can afford to pay.

However the table above certainly doesn’t reflect this. In all five unit trust categories investors paying performance fees are being charged more, but they are actually only seeing higher returns in two of them. Most investors in funds charging performance fees are therefore paying more, for less.

Concerns for investors

Morningstar itself has for many years been a vocal critic of performance fees, and believes that they are seldom in the best interests of the investor. Particularly in the South African environment, they believe there are four key reasons why these fee structures are prejudicial.

The first is that they are typically asymmetrical. There are a minority of exceptions, but in general funds that charge performance fees charge them on top of a base management fee.

This means that the manager can never lose. No matter how bad performance is, they are guaranteed their base fee. They therefore earn extra fees when performance is good, but share none of the downside with investors, who keep paying regardless.

Secondly, many benchmarks or performance hurdles are inappropriate and not aligned with investor expectations when it comes to risk and performance. If you invest in a fund that invests primarily in equities, for example, its benchmark should be an equity index, not a peer average or another asset class altogether, such as cash.

Morningstar’s third concern is that performance fees can still be charged even if funds deliver negative performance. For instance, if a fund uses the FTSE/JSE All Share Index as its benchmark and the index falls 20%, the fund will still have beaten the benchmark and can still charge performance fees if it only falls 19%.

This means that investors can be paying performance fees, even though they are actually worse off. That brings into question the assertion from fund managers that performance fees ensure that investors only pay “when they can afford to”.

Finally, Morningstar argues that the methodologies used to calculate performance fees are complex and difficult for investors to understand. This is because no matter what time frame you use, there are intricacies to how they are calculated.

Unit trusts in the multi asset and equity categories are typically long term investments, and therefore what should concern investors is performance over periods of five or ten years. However it is impossible to charge performance fees over such long time periods, because it would mean that any new investor would be paying for years of performance that they didn’t experience.

If a fund charges for performance over shorter periods, however, it is not aligning its fees with its mandate. Which means that, ultimately, there cannot be a satisfactory performance fee structure.

Globally, there has for some time already been a move away from performance fees and in South Africa too, there are signs that they are slowly falling out of favour. Old Mutual removed the performance fees from a number of its funds last year, and Coronation also did away with some performance fees when it went through a recent review.

This trend is unlikely to stop. As investors become more aware of what they are paying, they are increasingly going to demand fairer fee structures. And performance fees are going to be harder to justify.

• This article is brought to courtesy of Moneyweb