Unfair tactics used by some asset managers against you, the investor
Asset managers often argue that performance fees are fairer to you, the investor, than set asset management fees, because you pay only when your manager delivers returns above the investment’s benchmark.
But there are three major ways in which these fees may be very unfair on you, Brandon Zietsman, chief executive officer of PortfolioMetrix, which provides asset management services to financial advisers, relates in articles published on www.adviser.co.za.
His examples highlight some of the issues National Treasury has raised on performance fees in its recent paper, “Charges in South African Retirement Funds”.
SKEWED PLAYING FIELDS
Zietsman says the first problem is that the playing fields are not level – the manager takes without limiting the performance to which the fee applies when returns are good, but gives up only a limited amount when returns are below the benchmark or the performance fee hurdle.
An example of how these performance fees work is where a fee of one percent of the investment is charged if returns equal the benchmark, but the manager takes 15 percent of any returns above the benchmark without any limit on the percentage of assets that can be charged as a fee, Zietsman says .
When returns are below the benchmark, the fee decreases, but only to a minimum of 0.5 percent of the investment, he says.
Zietsman says funds have periods of outperformance and underperformance, regardless of whether, on average, they actually beat the benchmark over time. These deviations may be quite marked, especially when a manager invests in a portfolio that bears little resemblance to the benchmark. The difference between the portfolio and the benchmark is ultimately what drives outperformance and is what investors are prepared to pay for. But what you don’t want to pay for are random fluctations, Zietsman says.
He says such a fee structure was tested in a simulated environment on a fund that only delivers the benchmark returns over time and that has a tracking error of 11 percent (the degree to which actual returns differ from the benchmark returns). The test showed the fund was likely to attract a fee closer to 1.5 percent than the one percent you would expect to pay for returns equal to the benchmark.
Zietsman says the additional 0.5 percent was simply a result of a fee structure that allowed for limited participation in outperformance, even when the fund was not outperforming its benchmark at all. This shows how the playing fields are not always level, he says,
Zietsman says caps or limits on the fees that can be charged when performance is good – which are known as high-water marks – can be used to help level the playing fields.
High-water marks ensure you do not pay fees for outperformance unless it is new outperformance above the previous highest outperformance.
PAYING FOR HISTORY
A second problem with performance fees highlighted by Zietsman is that you end up paying for performance you did not necessarily enjoy.
He cites the case of a fund that launched more than 14 years ago and has returned, on average, eight percent a year better than the benchmark for its investors.
However, the fund delivered extraordinary performance in its first year. Investors who invested in the fund a mere one year after its inception received a return of four percent a year above the benchmark, half of that for the full period. Zeitsman says this shows how timing matters. He says fees are often based on performance achieved over rolling periods – two years in this case – and if fees are based on a period that includes a year of good performance that you, as an investor, missed, you may well pay more than you should for what you actually received.
The fund returned 17.19 percent in 2008 but lost 28 percent relative to its benchmark index between February 2009 and February 2012. Investors paid an average fee of 2.51 percent a year in fees over those three years of negative performance because of the good performance in 2008.
The fund’s performance fee is based on a 10 percent participation rate in out- and underperformance, but this is potentially misleading, because it is based on a two-year rolling period. Each year is effectively included twice, which means the actual participation rate is closer to 20 percent a year.
The third problem with performance fees that Zietsman and National Treasury highlight is that your manager may choose a benchmark or performance fee hurdle that is inappropriate.
Zietsman says some multi-asset funds use the average performance of their peer group as the basis for the performance hurdle that must be cleared before the fee applies.
But, he asks, if the managers act as a herd and make the wrong investment decisions, and your manager also makes the wrong decisions but is just a bit less “dof” than the rest, does that entitle it to charge a performance fee?
Another big problem with performance fees is that some managers base their performance hurdle on inflation as measured by the consumer price index (CPI), Zietsman says.
“Inflation simply isn’t an investable asset. Again, this means that much of the performance fluctuation around an inflation benchmark over one or two years is simply random.”
He says he is aware, for example, of some multi-asset funds that have an aggregate weight in equities of more than 65 percent of the fund, which charge performance fees for performance that exceeds CPI plus five percent.
However, between June 2004 and June 2012, if you passively held a similar asset allocation to these funds in the appropriate underlying indices (without active asset allocation or stock selection), you may have achieved a return of around 17 percent a year, while inflation was about six percent a year.
Hence, a passive investment that would have required no more effort than balancing the asset class weights back to the benchmark asset allocation would have delivered a return that was 11 percentage points above inflation for this period.
He says some managers, but not all, genuinely seek to make their fee structure fair, but the complexity of performance fee calculations makes it virtually impossible for consumers to identify all the problems.