FMA tackles performance fees

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[UPDATED] Fund managers are being told they must make it clear to investors that they may be paying a performance fee twice for the same return if they do not use a high-water mark.

Tuesday, March 1st 2016, 6:00AM 2 Comments

The Financial Markets Authority has released an information sheet explaining how it expects fund managers to disclose performance-based fees to investors.

It said a high-water mark would ensure that a manager who lost money must do more than recover before it started charging a performance fee.

“The FMC Act does not require the use of a high-water mark,” the FMA said. “Investors however, will be affected by the absence of one. The absence of a high-water mark means the fund manager may be rewarded for the same performance, and this must be clearly explained to investors in the product disclosure statement (PDS). Failure to do so would most likely result in a fee description that is misleading.”

It said managers would need to make it clear in a PDS if a high-water mark did not apply and what that would mean.

It suggested managers say: “The impact of this fund not applying a high-water mark is that if this fund drops in value and then recovers, you may be paying a performance fee twice for the same return, once for the recovered growth, as well as the original growth.”

Jeremy Muir, of law firm Minter Ellison Rudd Watts, said the issue of high-water marks was a contentious one. "It is a subject where different fund managers can hold quite different views and there has been vigorous debate.

"The FMC regulations, for example, don't mandate express disclosure around high-water marks. The FMA's information sheet, however, suggests wording to use in a PDS, including where there is no high-water mark. Some submitters were of the view that it should not be permitted to charge a performance fee without a high-water mark at all. As the FMA points out, however, the legislation does not go so far. Compare this to the situation for KiwiSaver schemes where all fees must be 'reasonable' and the FMA has published its expectation that performance fees should contain a high-water mark which cannot be reset."

The FMA has also offered guidance on the indexes performance fees are tied to.

“All managed funds are required to report their performance as part of the fund update. This performance must be measured against the returns of an appropriate market index,” it said.

“The market index used must appropriately reflect market movements in the types of assets that the fund invests in. Although not a legal requirement, it is reasonable to link the hurdle rate for any performance-based fee to the returns of the comparative index.  Some funds currently base their performance fee on a hurdle rate of return linked to a market index that does not reflect the asset class and risks of the underlying investments.

“An example is equity-based funds that use a 90-day bank bill index as the hurdle rate of return. The impact of this is a fund may still be paid a performance-based fee although it has underperformed against the fund’s comparative index.”

It said when a fund’s hurdle rate of return was linked to a different market index, this should be clearly disclosed to investors so they could understand the implications of the decision. Muir said: "Thos efund managers who adopt this approach will need to ensure that the proposed wording does not create a negative impression for investors."

Tags: FMA Performance fees

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