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Taking the rough with the smooth

The case for performance based fees - Rob Hosking weighs up the pros and cons.

Wednesday, August 20th 2003, 1:56PM

by Rob Hosking

The case for performance based fees - Rob Hosking weighs up the pros and cons.

The “heads I win/tails you lose” nature of the relationship between fund managers and investors has long been the source of much investor teeth-grinding.

The long bear market has caused the issue to come to the fore yet again. Investors are asking, if their investment has lost money, then why are the fund managers getting paid bonuses?

It’s a fair question. Some fund manager firms are replying that if, say, a fund made a loss of 6% and the market went down 12%, the manager still beats the market – and is entitled to a bonus. The problem for the investor of course is that if the return has still gone down by 6%, the money for that bonus has to come from somewhere. And when the music stops, it’s the customer who is left holding the silly parcel.

This has led to a push in some countries for more performance related fees. Here, though, that drive has not been as strong.

“It hasn’t come up at all with the advisers, and managers, that I’ve spoken to,” says FundSource business manager Tim Anderson.

“The only exception is the new St Laurence fund.”

Wellington-based St Laurence group last month launched its new Number One Portfolio Trust, a group of five separate funds which have a minimum level of return. If the returns drop below that ‘floor’, there are no fees.

“We see Number One Portfolio Trust as a way of signaling to investors that we are putting their interests first and not the other way round,” says St Laurence managing director Kevin Podmore.

“It’s fair to say that there aren’t a lot of products and services in the marketplace that have this philosophy, but we’re prepared to back our judgment and put our fee on the line.”

The fund was launched specifically because of investor anger over having to continue to pay fees while portfolios shrink in value, he says.

But so far St Laurence is the only company taking this approach, says Anderson.

However, Anderson says that investors should not make their decision based on management fee structure.

He likens picking an investment based on fees to picking it based on tax – yes, it is an issue, but it should be secondary to the overall strategy.

“There are other, more important issues than fees. They shouldn’t be a pivotal reason why an investor selects a vehicle – they should first consider what their goals are, and whether or not that investment will meet those goals.”

Watson Wyatt’s international arm put out advice on performance fees for fund managers a couple of years ago and, while broadly supportive of the idea, noted the pitfalls.

The pluses are not only that it makes the investor happier, but it also more closely aligns the interests of the investor and the fund manager.

“It also encourages greater realism when the fund manager is setting future return predictions.”

However, they can be complex to administer.

“Other shortcomings are that performance related fees can encourage investment managers to take higher levels of risk in an attempt to boost their fee, and there is also a possibility that short-term market movements may overshadow the true effect of the investment manager's skill.”

Which, in turn, means that any performance related fee needs to be based on the mantra of which wary investors in equities are frequently reminded – you need to focus on the long-term return. Setting a performance related fee based on long-term performance can be tricky – just how long should it be? The Watson Wyatt guidelines suggest three years. They also suggest capping the fee at a level of performance that involves an acceptable level of risk.

There is one final drawback for fund management firms considering performance based fees. Like any other firm, they need to hang on to their best staff. If performance related fees mean fund managers take too big a drop in their expected income, they may move to other firms which do not have such an arrangement.

Rob Hosking is a Wellington-based freelance writer specialising in political, economic and IT related issues.

« St Laurence says: forget feesStrength, stability and service »

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