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:

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:

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?

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