Treasury unhappy about fund performance fees
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