Trea­sury un­happy about fund per­for­mance fees

Weekend Argus (Saturday Edition) - - PERSONALFINANCE -

As­set man­agers charg­ing per­for­mance fees for man­ag­ing your sav­ings have had a warn­ing shot fired across their bows by National Trea­sury.

Trea­sury’s con­cerns about the ef­fect of per­for­mance fees on to­tal costs to re­tire­ment funds are ex­pressed in its dis­cus­sion doc­u­ment re­leased last week on charges in the re­tire­ment fund­ing in­dus­try.

The con­cerns fol­low the in­creas­ing ten­dency in re­cent years for lo­cal as­set man­agers to charge per­for­mance fees even on some en­hanced, pas­sively man­aged ex­change traded funds.

Most of­ten th­ese fees, which may be levied on both re­tire­ment fund as­sets and unit trust funds, are charged on top of an­nual as­set man­age­ment fees, which are, in any case, a type of per­for­mance fee, be­cause the bet­ter an as­set man­ager per­forms, the greater the value of the as­sets man­aged and the greater the man­age­ment fee.

Trea­sury says about 20 per­cent of lo­cal unit trust as­set man­agers ap­pear to be us­ing a com­bi­na­tion of as­set­based fees and fees based on the re­turns of their port­fo­lios – in other words, per­for­mance fees. It also says that some as­set man­agers that choose to be rewarded on the ba­sis of per­for­mance fees – in­clud­ing some ma­jor com­pa­nies – are us­ing in­ap­pro­pri­ate bench­marks to mea­sure per­for­mance.

“Many in­vestors ap­pear to be­lieve that out­per­for­mance rel­a­tive to th­ese bench­marks re­flects ei­ther man­ager skill or man­ager out­per­for­mance. This sug­gests that few in­vestors in South Africa and in­ter­na­tion­ally – are able to as­sess the mer­its of per­for­mance fees,” the doc­u­ment says.

It says that in the United States per­for­mance fees ap­pear to be quite rare, al­though they are more com­mon in Europe. It re­ports rapid growth in the preva­lence of per­for­mance fees in Bri­tain and Aus­tralia.

Trea­sury says as­set man­agers that have out­per­formed in the past are more likely to im­ple­ment per­for­mance fees than as­set man­agers that have un­der­per­formed.

Trea­sury ac­cepts that, in prin­ci­ple, per­for­mance fees may be one way of align­ing the in­cen­tives of fund man­agers and in­vestors to the ex­tent that ac­tive man­age­ment can gen­er­ate higher re­turns. Per­for­mance fees give man­agers greater in­cen­tives to seek the high­est re­turns pos­si­ble.

But Trea­sury says per­for­mance fees may also have poor in­cen­tive ef­fects. Its con­cerns in­clude:

When as­set man­agers are not able to sys­tem­at­i­cally gen­er­ate out­per­for­mance, “per­for­mance fees re­ward luck rather than skill”. It says that there is re­li­able ev­i­dence that man­agers can­not, af­ter costs, con­sis­tently out­per­form mar­ket in­dices.

Per­for­mance fees mag­nify the in­cen­tives of man­agers to en­gage in what is called “tour­na­ment be­hav­iour”. Trea­sury de­fines this as the sys­tem­atic ad­just­ment of risk in a port­fo­lio, de­pend­ing on whether per­for­mance is ahead of or be­hind the bench­mark, in or­der to max­imise the fees. This harms in­vestors. For ex­am­ple, if an as­set man­ager is ahead of a bench­mark, the man­ager may re­turn the port­fo­lio to the bench­mark in or­der to “lock in” out­per­for­mance. If per­for­mance is be­low the bench­mark, the man­ager has a strong in­cen­tive to in­crease the di­ver­gence be­tween the bench­mark and the un­der­ly­ing port­fo­lio to gen­er­ate out­per­for­mance, ex­pos­ing in­vestors to higher risk.

A re­cent study in Bri­tain by ac­count­ing firm Grant Thorn­ton con­cludes that, from 2003 to 2007, per­for­mance fees had lit­tle ef­fect on man­ager per­for­mance, and that their main ef­fect “ap­pears to have been to in­crease prof­its for as­set man­agers”.

Bench­marks are of­ten not ap­pro­pri­ate. A good bench­mark, against which per­for­mance is mea­sured, needs to en­sure that only gen­uine out­per­for­mance is rewarded. A good bench­mark should:

Re­flect the fun­da­men­tal risk and re­turn driv­ers of the port­fo­lio;

Re­flect a trad­able in­dex, such as the FTSE/JSE All Bond In­dex, rather than some­thing such as the con­sumer price in­dex (CPI) in­fla­tion plus two per­cent;

Be fully in­vestible or “free-float” based – for ex­am­ple, the FTSE/JSE Swix rather than the FTSE/JSE All Share In­dex. The Swix down­rates the dom­i­nant in­flu­ence of large off­shore, dual-listed com­mod­ity com­pa­nies;

Be a to­tal- re­turn in­dex that in­cludes rein­vested in­come (div­i­dends and in­ter­est) rather than one that re­flects only cap­i­tal val­ues;

When de­ter­min­ing per­for­mance fees, per­for­mance should be cal­cu­lated by com­par­ing the man­ager’s net (af­ter-cost) per­for­mance against the gross bench­mark, since the case for ac­tive man­age­ment and per­for­mance fees rest on net out­per­for­mance.

The cal­cu­la­tion should be ad­justed for cash flows, which can af­fect val­ues, de­pend­ing on the tim­ing of in­vest­ments.

As many fac­tors as pos­si­ble that are be­yond the man­ager’s con­trol should be purged from the eval­u­a­tion of his or her per­for­mance by re­flect­ing as closely as pos­si­ble the man­ager’s cho­sen in­vest­ment style (for ex­am­ple, a “value” man­ager should be eval­u­ated against a value in­dex).

Other fac­tors Trea­sury says should be taken into ac­count when per­for­mance fees are levied in­clude:

There should be lim­its on the risk lev­els of the un­der­ly­ing port­fo­lio to pre­vent as­set man­agers from tak­ing ex­ces­sive in­vest­ment risks or show­ing ex­ces­sive cau­tion in the pur­suit of per­for­mance fees.

Per­for­mance fees should be sym­met­ri­cal. In other words, when they un­der­per­form, as­set man­agers should for­feit an amount equal to what they earn when they out­per­form.

An­nual as­set man­age­ment base fees should be lower to al­low for per­for­mance fees.

The pe­riod over which the per­for­mance is mea­sured, the method of cal­cu­lat­ing out­per­for­mance, the ef­fects of any weight­ing or smooth­ing of per­for­mance, and the level and cal­cu­la­tion method of any high-wa­ter marks (the level above which per­for­mance fees are charged), par­tic­u­larly in volatile mar­kets, should be clearly dis­closed and un­der­stood by in­vestors.

Fees that as­set man­agers award them­selves af­ter scor­ing re­turns for you above a bench­mark are in the spot­light fol­low­ing a dis­cus­sion pa­per on in­vest­ment costs by National Trea­sury. Bruce Cameron re­ports

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