As performance-related fees become more commonly levied on investment trusts, investors will find it increasingly difficult to make accurate comparisons of charges, according to a recent study by Merrill Lynch*. The difficultly arises because there is no standard practice for calculating performance-related fees. Merrill Lynch warns that the sector may suffer unless performance-related fees are carefully structured.
In a review of 180 investment trusts, with a combined total market capitalisation of more than £43bn (E70bn), Merrill Lynch found that 42 funds were tying their fees to their performance; of these 17, began this new system of charging during 1999.
Performance-related fees have a few obvious strong-points. They align the interests of shareholders and fund managers by ensuring that both benefit from improved results. In addition, in theory at least, shareholders benefit from lower fees during periods of weaker performance, as long as the performance component of the fee is balanced by a corresponding lessening of the basic management fee.
The study points out that the charging of management fees is not a clear-cut matter: “Some performance fees require a degree in law to understand the details of the agreement and then demand a PhD in statistics to calculate what fee should be charged.” The authors advocate keeping the principles behind the performance-related fee simple and easy to communicate to potential shareholders.
One of the keys to a fairly assessed performance-related fee is the establishment of an appropriate benchmark against which the fund’s performance is judged. First, the benchmark should accurately reflect the fund, bearing “a close relationship to the universe from which the manager is picking his stocks”. If no close match exists, the fund has two options: either to create its own index by amalgamating two (or more) others; or to use a broader index as a benchmark. While the second method is common, for instance among global specialist sector funds such as Henderson Technology, or for funds of funds like the World Trust Fund, it has a definite weakness. “The key problem with such fees is that management can be rewarded simply because of differences in the composition of the benchmark and the fund’s universe. For instance, a global technology manager would have struggled to underperform the FT World Index over the past year.”
A few funds measure themselves against an absolute-return benchmark. These include International Biotechnology, Finsbury Technology, Amerindo Internet Fund and 3i Bioscience (on unquoteds only). However, the report cautions against this practice: “In our view, for most funds investing in quoted equities, it is relative, rather than absolute, returns that should be measured ... otherwise there will be years when index trackers, or even poorly performing funds, could earn substantial fees. We believe the managers should be rewarded for their stock-picking abilities and not just for moves in the overall stock market.”
Performance-related fees also have to be structured in such a way that they encourage steady, good performance, rather than volatility. Most performance fee agreements do take this into consideration, using one of three methods. Some funds establish a high watermark: “This represents a hurdle to ensure that the managers can only be rewarded for outperformance after recognising any previous underperformance since the last incentive fee was earned.”
Other funds put a cap on the performance fee: “a cap of 1.5% p.a. of asset would only be exceeded if the fund outperformed its benchmark by more than 15 points ... If the manager is outperforming by more than this in any single year, it has to be questioned whether he is taking on too much risk or if the benchmark is a true measure of his investment universe”. Still others spread the payment over a certain period: “For instance, Fleming American divides the performance fee due in respect of any single year into equal parts payable over three years”. Any negative fee resulting from underperformance is deducted from any unpaid fees carried forward from prior years. The report recommends measuring over a rolling, three-year period, as well as capping the fee.
The report also recommends that the manager share in any downside, either by lowering the base fee or penalising underperformance. While the majority of funds included in the study did reduce their basic management fees, by 0.1% to 0.5%, few penalise underperformance. The Finsbury Growth Fund varies its basic management fee of 0.75% by 0.02% for each 1% of over or under performance of gross assets per share against the All Share, with a maximum fee of 0.87% and a minimum of 0.63%. Scottish American pays 10% of NAV total return outperformance, but also charges 5% of underperformance, capping both at 1.5%
*Management Fees: Are Performance Related Fees Good for Shareholders?, issued by Merrill Lynch & Co, London