Fund managers on to a fees winner

Low interest rates may be lining some fund managers’ pockets.

The Financial Markets Authority has released the findings of its review of quarterly fund updates provided by managed investment scheme (MIS) managers, including KiwiSaver providers.

The managers have to provide estimates of the variable fees they charge in their product disclosure statements (PDS) given to prospective investors.

In their quarterly updates they report on the actual fees charged.

The authority said 17 per cent of the schemes it looked at had a fund update that included fees materially higher (+ 0.15 per cent) than in the PDS, or 9 per cent after excluding funds where the PDS was subsequently updated.

It found in some cases that was due to performance fees being higher than expected. Performance fees are variable charges that managers impose on a portfolio when it performs beyond a set benchmark, or hurdle.

The FMA found 11 instances where they were charged. At least four of them 11 had ‘‘high risk’’ features such as high-water mark resets or a hurdle rate of return of nil.

A spokesman said those features were not regarded as best practice. None of the four were KiwiSaver schemes.

‘‘A performance fee is payable on the excess return above the hurdle rate of return. If we have noticed a hurdle rate of return of nil, then this means a performance fee is charged on the entire performance of the fund, rather than what the fund manager is delivering above and beyond market performance,’’ he said.

‘‘On the issue of high-water mark resets, the high-water mark is the highest unit price or net asset value per share achieved at the end of any performance fee calculation.

‘‘No future performance fee is payable until the high-water mark has been exceeded. High-water marks apply to ensure that past underperformance is recovered prior to the accrual of any future performance fee.

‘‘If there is a reset provision, it enables the manager to reestablish either the high-water mark or the hurdle rate of return, thus making it easier for the fund manager to earn performance fees.’’

Chris Douglas, of research house Morningstar, said it was important that performance fees were fairly structured. In New Zealand, most favoured the fund manager.

Many of the structures were set up when the official cash rate was high, Douglas said. Managers who had a different investment style to the index did not think that benchmarking against an index was appropriate – but a hurdle of the cash rate plus 4 or 5 per cent gave them a hurdle of as much as 13 per cent return before fees were charged.

‘‘If you’re not a sophisticated investor that sounds quite good. You don’t pay performance fees if the returns are negative or if they are below the hurdle. And you share the upside with the fund manager.’’

But he said it was problematic in situations such as recent years where the market had delivered returns as high as 20 per cent or more.

‘‘Due to no skill of the fund manager, just the performance of the market, they get very healthy returns and investors are paying quite a high fee for that.

‘‘Now the cash rate is at historic lows, a lot of funds benchmark against the cash rate or term deposits and that’s a very low hurdle when in 2017 New Zealand equities returned 20 per cent or more.

‘‘The reality of the market we had last year means fees are going to be much higher for the year to March 31.’’

The FMA says it will work with managers to address the issues uncovered by the review.

Douglas questioned what it could do. KiwiSaver managers had been given a guidance note on performance fees and there had been no change in behaviour as a result.