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The perfect performance fee: Part One

Performance fees are intended to reward fund managers for outperforming the market and generating above average investor returns.  Each performance fee has several moving parts for which there is currently no market standard in New Zealand.  In this two part commentary John Berry looks at fair and unfair performance fee features, and thinks about how a fund manager might construct the perfect performance fee.

Wednesday, October 1st 2014, 1:47PM 6 Comments

by Pathfinder Asset Management

Performance fee components 

Performance fees are intended to both encourage and reward excellence in funds management.  They are not standardised so understanding and comparing them can be far from simple.  Here is a performance fee description which we will use in this commentary –

If the return after fees of a fund exceeds a hurdle rate then the manager receives a share of the excess gains. The hurdle rate will be the market return (measured by an appropriate benchmark) plus a specified margin (reflecting risk taken by the manager above broad market risk).  The performance fee will only be payable where the high water mark (if one applies) is exceeded.

Preparing this article has involved reviewing the prospectus for each of 10 New Zealand PIE retail funds where a performance fee is charged.  The 10 funds invest in either domestic or international equities.  While the FMA has issued a guidance note for performance fees charged by kiwisaver providers, the focus of this article is non-kiwisaver funds.   Let’s start by going through each of the key performance fee components in turn:

Hurdle rate:  appropriate benchmark
The hurdle rate should be linked to a benchmark fairly reflecting the asset class and risk of the underlying fund investments.  This means if the fund is an equity fund then some sort of equity benchmark is appropriate.  For example an NZ share fund may use the NZX50 index and a US equity fund the S&P500 (in each case including dividends).  A bond fund should use a bond index.

But there is no simple answer.  If the fund uses an absolute return strategy then a hurdle referencing a cash rate may be more appropriate  – like OCR plus 5% per annum. 

Cash benchmarks are surprisingly popular for typical share funds in NZ – but can this ever be appropriate?  If the hurdle is linked to the OCR and the NZ equity market returns 20% over a year then a manager who returns market (or even less than market) is in a happy place.  The manager has not beaten the market but is entitled to back up the truck and load up the performance fee. 

Also a struggle is jusitfying a performance fee where there is no benchmark at all (this happens in 2 of our sample of 10 funds).  In this case the manager collects a percentage of all positive performance, regardless of what the market has returned.  This particularly hurts investors where fund performance has been mediocre.

Of the 10 equity funds examined, here is a summary of the performance fee benchmarks:

Benchmark type Number of managers
Cash (OCR linked) 3
Fixed annual hurdle (10% p.a.) 1
Equity linked benchmark 4
No benchmark (i.e. performance fee kicks in at 0%) 2

 Hurdle rate:  margin above benchmark
Hand in hand with the choice of benchmark is selecting a margin above benchmark that the fund must return before the performance fee is calculated.  For example if a fund is highly concentrated compared to the market or focuses on a more volatile niche like smaller cap companies, then investors should be compensated for extra risk.  It would not, for example, be fair to invest in only 10 stocks and be paid a performance fee for the return simply above the NZX50 – the risk is significantly higher and so a margin should be used to reflect this. 

Selecting the margin is important for not only equity funds but also other asset classes.  For example with bond funds if the fund can invest in low grade credit and the benchmark is sovereign or investment grade bonds, then this should be reflected in the margin. 

The table below summarises the performance fee margin for the 10 equity funds in our sample.  It is a surprise to see that only five of the 10 use any margin at all:

Margin type Number of managers
Margin above benchmark is used 5
Benchmark with no margin 3
No benchmark or margin (i.e. performance fee kicks in at 0%) 2

Share of the excess gains
How much of excess gains above the hurdle rate should the manager take? Is 10% appropriate?  Or 15%?  May be 20%?  There is no simple answer - deciding what is fair depends on whether you are asking an investor or fund manager.  What would seem fair is an above average share of excess gains going to the manager should be reflected in a below average base fee.  A share of gains at the lower end of the scale (10%) is popular with our sample 10 funds:

Share of excess gain going to manager Number of managers
10% 8
15% 1
20% 1

A high water mark

Performance fees should have a high water mark – so the fund unit price has to hit new highs before a performance fee kicks in.  This avoids the situation of a manger being paid a performance fee one year, losing money for investors the next, and then collecting another performance fee the following year as the losses are recovered.  You should not get paid twice for the same gain in unit price.

The good news is that nine of the 10 funds in our sample have a high water mark.  The bad news is that one fund has no high water mark and collects a performance fee even when it is making good prior year losses to investors. 

Three of the nine funds with a high water mark have the ability to reset.  This means the manager may be able to disregard the high water mark after poor performance and be paid a performance fee a second time without the unit price hitting a new high. 

For two funds this reset first requires “consultation” with the trustee – but consultation with the trustee is not the same as “consent of” the trustee.  It sounds much the same as a reset option that is at the manager’s discretion.   A perpetual high water mark (no reset) is better for investors.

High water mark position Number of managers
Perpetual high water mark 6
Three yearly reset after “trustee consultation” 2
Manager can reset high water mark at any time 1
No high water mark applies 1

Quick summary
Here’s some quick thoughts on an appropriate performance fee:

  1. The benchmark should reflect the nature and risk of assets invested in (can cash benchmarks for equity funds ever be appropriate?)
  2. A margin should be applied to the benchmark to reflect risk (delivering a market return with the same or more risk should not be rewarded with a performance fee)
  3. Fee calculations should include a perpetual high water mark (with no reset options)

Ultimately the manager can structure the fee and, if properly disclosed,  investors can decide by investing in the fund or by walking.  In Part Two of this article we will will look at disclosure issues (including tricky areas like performance fees charged on performance fees). We will also look at performance fee features we don’t see yet in non-KiwiSaver funds but we should be discussing (like performance fee caps).

John Berry
Executive Director
Pathfinder Asset Management Limited

Disclosure of interest - Pathfinder is a fund manager and does not charge performance fees on its funds.  Seek advice - Pathfinder does not give financial advice - seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors.

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Comments from our readers

On 1 October 2014 at 4:45 pm Richard Harden said:
Good article John and points that all AFA's need to be aware of. Always makes me laugh when you see the differences between managers. Performance reporting is another issue and I can't understand why some managers report before fees and then try and compare against their benchmark as well.
On 2 October 2014 at 7:32 am John Milner said:
These performance fees are a beautiful thing. Encourages managers to take on more risk with the clients money and is rewarded for doing so. If that doesn't work out the manager still gets their fee but no performance fee. Sweet deal for who?
On 2 October 2014 at 11:33 am Brent Sheather said:
Informative article but I think the best performance fee is no performance fee. What’s more part of the reason exchange traded funds are getting so much of the new investment money overseas is because many investors perceive performance fees as another example of fund managers extracting high rents. The latest figures on ETF growth that I read in the FT are astounding… investors are voting with their feet.
On 3 October 2014 at 3:45 pm ggreene said:
I think this article is spot on. This is a debate that's been raging for, and will continue on for years.

Performance fees are fine as long as there is a high water mark and it is benchmarked apppropriately. On top of this, all performance should always be reported NET of fees.

Logic would suggest a mix of the two is best. Management fee only structures simply encourage asset gathering which hurts performance. Performance fee only structures encourage a manager to take on too much risk. A sensible mix of the two is best for investors and the manager.

Richard - in answer to your question; managers argue that reporting gross performance is indicative of manager skill, however I would argue that this is not appropriate for retail investors, as they are 'consumers' and then end product they are buying is net of fees. Gross performance is fine for wholesale investors.

On 11 March 2015 at 10:56 am Mark Houghton said:
I'd like to make a couple of comments on the article and on the comments above.

Firstly I don't think you can talk about performance fees and not, in the same analysis address administration fees.

If a fund charges a very low administration fee, then a performance fee may be seen in a different light. In fact the performance fee may be the only reward a manager receives, so the issue of a benchmark or hurdle may be secondary to the issue of the overall cost to the investor.

Secondly, by far the greatest component of out-performance for any manager I have reviewed in my 25 years of being in this business comes from protecting capital when markets fall.

Performance fees will ultimately be earned from a managers ability to protect the downside. Rather than encourage risk taking, I have found performance fees to encourage risk reduction, because avoiding losses is central to long term wealth creation.

I believe performance fees are a very good way of aligning incentives between manager and investor, provided there is a high water mark, and provided administration fees are reasonable and transparent.

As concerns ETFs, yes huge flows in, but wait for the next correction in equity markets and you will see huge flows out, probably after considerable losses. If you do invest in an index-oriented strategy, then ETFs and index funds are by far your best option.

But if you want a manager to protect your capital when markets fall, you'll probably have to look beyond fees and look for talent.

NB: Warren Buffet, when looking for someone to manage some of his capital, selected a long/short manager in the US who charges performance fees!
On 11 March 2015 at 1:31 pm Pragmatic said:
Thanks Mark Houghton for a sensible perspective. Unfortunately the rising tide has left many investors to focus on price and not value. I suspect that preservation of capital will be of more interest to these folks once the inevitable correct in inflated equities markets occurs...

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