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(Under) performance fees

Pathfinder's Paul Brownsey does some calculations on performance fees and finds some answers which should surprise advisers and investors.

Thursday, June 4th 2015, 6:30AM 7 Comments

by Pathfinder Asset Management

The FMA has made good progress improving the experience of investors in managed funds.  Manager disclosure is better and some of the worst forms of behaviour have gone.  One remaining grey area that needs a lot of work however, is performance fees. 

There is no consistency among New Zealand managers on how performance fees are designed, implemented and measured.  There is little thought leadership or discussion by the funds industry around the philosophy and appropriateness of different performance fee structures.

Performance fees can be appropriate if designed to truly align interests with investors – but the philosophy behind them needs to be made clear.  This article challenges the philosophy of many performance fee structures through two “what if” questions:
 

“What happens if purely passive funds charged performance fees in the same way actively managed funds do?”
and secondly:

“What impact would there be on investors in actively managed funds that do not currently charge performance fees if performance fees were charged?”

In each case the focus is what do the performance fees mean for an investor’s experience?   Fund management fees are a zero sum game – every dollar of fees paid to the manager is a dollar that is not going into the investor’s pocket.

What if passive funds charge performance fees?
The answer to this question should of course be that a passive fund never earns a performance fee.  It is delivering a market return and so should not be achieving (nor getting paid for) outperformance.  But the reality is very different because many performance fee structures are not based off a market return.

To illustrate this point we adopt the performance fee structures of three international equity funds.  These are all PIE funds sold to retail investors in NZ.  In each case we assume a fund size of $50m and compare the performance fee that the fund would have charged (based on its actual returns to 31 March 2015) and what a purely passive exposure would have charged.

For the passive international exposure we use the MSCI All Country World Net Index with 50% in local terms/50% in NZD terms.  This is widely used by NZ funds and investors as a performance comparison, as it represents both the equity universe and currency impact.   (Note - we have not deducted fees from the passive exposure but believe that this is an appropriate approach.  The investment thesis of every manager is or should be that they can beat a passive exposure on an after fees basis).

Surprisingly the passive return of 18.1% outperformed all three of the comparison active funds by between 1.3% and 8.5% for the year.  The three performance fee structures (manager share of returns and hurdle rates) are set out below:

Fund Manager share of excess return Hurdle rate (threshold above which performance fee is earned) Actual hurdle rate (%)
(for year to 31/3/2015)
A 10% above 0% 0%
B 15% above OCR + 5% 8.35%
C 10% above OCR + 4% 7.35%

While we are only showing a small sample, there are plenty of examples of ”0% hurdle” or “OCR plus” performance fees in NZ.  We have only referenced NZ funds - there are also higher fee examples from several Australian unit trusts sold in New Zealand. 

Now using actual fund returns to 31 March 2015, and an assumed fund size of $50m, we calculate what the passive fund would have earned with the same performance fee structure:

  Passive fund:  $ performance fee Passive fund: 
% of FUM
Fund A fee structure $905,000 1.8%
Fund B fee structure $731,000 1.5%
Fund C fee structure $538,000 1.1%

So the passive fund earns handsome performance fees of between 1.1% and 1.8% for delivering market returns, and handily outperforming our three active funds.  These performance fee structures are just a little bit too manager friendly.  They don’t strike a fair balance between manager profitability and delivering an investment return above passive market performance. 

Remember when the manager told you “Performance fees are all about alignment of interest?”  Ask them “Whose interest?”

After recovering from the shock of realising that passive funds deserve a handsome performance fee, we move on to the second question.

What if active world equity funds that do not charge performance fees adopted performance fees?

A small number of New Zealand PIE fund managers with international equity funds do not charge performance fees.  We use OneAnswer International Share Fund, Pathfinder World Equity Fund and ASB EasyFund World Shares Trust here as examples. Pathfinder is not a fund-of-funds structure and has no performance fees at any level of the fund, we believe OneAnswer and ASB also do not have underlying performance fees.  If we take the actual fund performance of these three funds to 31 March 2015, what performance fee would have been charged? 

How would this impact on their investors?

  Performance in 2015 FY
(after fees)
Performance fee if based on Fund A structure (%) Performance fee if based on Fund B structure (%) Performance fee if based on Fund C structure (%)
OneAnswer 25.4% 2.5% of fund 2.6% of fund 1.8% of fund
Pathfinder 25.3% 2.5% of fund 2.5% of fund 1.8% of fund
ASB 20.9% 2.1% of fund 1.9% of fund 1.4%of fund

For these three fund managers (OneAnswer, Pathfinder and ASB) their investors would have suffered if performance fees were charged.  But the money would not have evaporated - the loss to investors would have been a gain to shareholders of the manager.  

Note that the lowest performing of these three non-performance fee funds outperformed the three high performance fee funds by between 4.1% and 11.3% in financial year 2015, and the passive alternative by a respectable 2.8%. 

Investors and financial advisers need to challenge managers who collect performance fees for less than market performance.  Investors and financial advisers should also challenge the thinking that a manager needs a performance fee to ensure good performance – the evidence does not support this assertion. 

Mediocrity instead is often rewarded. 

There is also a subtle risk impact from high levels of performance fees.  Research shows that performance fees encourage portfolio managers to take more risk, evidenced by more concentrated portfolios and higher tracking errors.  And the return that flows through to investors is after fees, but the risk taken to generate that return is on a pre-fee basis. 

Performance fees change the risk/reward payoff – managers will claim this is to the benefit of investors but this is not necessarily true, and certainly not true when a manager fails to achieve a passive benchmark.  In a future commentary we will look at the offshore experience and the international evidence in favour (or not) of performance fees, We also consider what the trends are in bigger and more mature markets like Europe and the US.

It would be beneficial to investors if performance fee calculations were more transparent, consistent across managers and struck at levels that are fair to both parties.  Performance fees should only ever be paid for investment returns that are superior (not inferior) to market returns.

Paul Brownsey
Director, Pathfinder Asset Management

 

Tags: Pathfinder Asset Management Performance fees

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Comments from our readers

On 3 June 2015 at 1:49 pm Paul Brownsey said:
After publishing this article I came across the following quote by Samuel Lee formerly an ETF strategist at Morningstar USA:

"My fourth lesson is that incentives are everything, but many investors are oblivious to their power.
If you put a good person in an environment where bad behavior is rewarded, the good person will do bad things. Many of the flaws of the finance industry can be traced to bad incentives. For example, for-profit managers that charge asset-based fees have a very strong incentive to accumulate assets and engage in closet indexing to avoid being fired, when investors would benefit from managers with capped assets and highly active portfolios. The lack of persistence in outperformance among mutual funds can in large part be attributed to the fact that hot performers tend to accumulate assets far beyond the point where their scale works against them. Investors do not penalize asset gatherers, so asset gathering and marketing is rife.

This is why a manager’s integrity is so important. The main thing keeping investment managers from
engaging in rent-seeking is their internal value system. Do the leaders of the firm care about winning
and treating their investors well more than they care about enriching themselves? Only a handful of managers will pass this hurdle."

On 4 June 2015 at 7:43 am Pragmatic said:
Thanks Paul - a useful article

Whilst the majority of performance fees are designed to align interests for mutual benefit, there will always be those who exploit this. A more significant crime is the number of capabilities that continually & repeatedly deliver nil / negative performance (in both absolute & relative terms) and yet, they continue to receive an ongoing management fee. Irrespective of the size of this fee (as they are often ‘sold’ as being a low entry point into sectors / markets), the Manager gets paid at the expense of the investor…

This concept of price versus value also extends into the advice space, whereby a number of advisors are lured into promoting their investment solutions based on the cheap price.
On 4 June 2015 at 9:20 am Dirty Harry said:
Is there any such thing as "outperformance" in a passive fund? What, exactly is outperfomance in a fund that, in theory should do whatever the market does?

Can wait for Mr Passive himself (Brent) to comment here regarding passive underperforming but getting the big fees. The allegations here are certainly going to spark a flame.
On 4 June 2015 at 10:14 am Paul Brownsey said:
Dirty Harry: I think the point I am making is that based on the performance fee structure of many active funds sold in NZ, if applied to a passive exposure, the passive exposure would generate a nice fat performance fee. That's clearly not a sensible outcome yet because these performance fee structures are skewed so heavily in favour of the manager at the expense of the investor, that would be the unfortunate result. I'm not advocating here for a passive approach, though on these examples passive has significantly outperformed the active funds with bad fee structures that I refer to.

Managers shouldn't earn a performance fee for beta.
On 4 June 2015 at 10:40 am Dirty Harry said:
Re-reading my own comments I can see my error. Was meant to say 'active underperforming but getting the big fees'.

My first question stands: How does one define "outperformance" in a passive fund? I just don't know whether they should be benchmarked against anything - would it be fairer to investors for it not to be part of the discussion?

And I agree that there is little place for performance fees where integrity and alignment of interests are genuinely there. A fund that meets or exceeds its expected returns should not expect a fat bonus like they have done something extraordinary - I prefer to call it "doing their job".
On 4 June 2015 at 11:53 am Pragmatic said:
I would extend Paul’s response by suggesting that any fund that is unable to deliver above the cash rate + an acceptable risk premium (ie: 2.5% + 6%) shouldn’t be paid anything – management fee included. I’m currently staring at a global equity fund that has delivered an average of 13.7% against a benchmark of 14.3%pa for 3 years and still charges 1.10% a year for the privilege! Here’s another one: -0.7%pa average performance, and still charging an annual management fee of 0.75% - with 100% of the fund currently in cash! Go figure.
On 5 June 2015 at 9:59 am R1 said:
I would suggest that these 'incentive' schemes for fund managers simply attract managers with the greed gene (a bit like the banks and their bonus schemes) rather than people who genuinely want to do the right thing by their clients and get paid a fair salary for a job well done. With short term performance rewarded handsomely under performance benchmarks loaded toward the manager it simply magnifies the temptation for greedy people to work in their own best interests, take the cash and move on to another place when the fund inevitably begins to underperform. Would be interesting to see a chart of where fund managers have spent time over their careers. Also, the returns received for clients Vs a valid benchmark during their tenure would be interesting; should be public data really.

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