Inherently the concept of performance fees is appealing. The plan sponsor only pays for performance when the manager delivers, and the manager has additional motivation to perform. However, a lower fee is poor compensation for cost of the poor performance it accompanies, and managers, in the pursuit of higher performance, might take bigger risks.
Performance fees add an additional volatile factor to a fund manager’s earnings, for which he will expect to be compensated. The standard flat fee as a percentage of underlying assets already makes the fund manager a hostage to stock market fortunes. Reducing the annual fee and adding a performance fee introduces another element, the manager’s own performance against the market, to the mix. To compensate for this additional optionality in earnings, managers will negotiate performance fee arrangements in such a way as to achieve a higher expected fee on average.
Because Andrew Hutton, head of investment management at Coutts, does not want to pay good managers more, Coutts has taken the decision not to award performance fees to any of the managers in its long-only multi-manager product. Comments Hutton, “a manager will price its services on its expectation of returns, and will try and secure as much income from the good years as possible to compensate for the bad. By agreeing a performance fee with a manager whom we are confident will perform, we run the risk of increasing costs.”
In contrast, Gareth Derbyshire, director of the European pensions group at Morgan Stanley, suggests that in the early stages, managers may have unrealistic expectations of their potential performance and negotiate fees that are too low. “In an effort to win mandates, managers may find themselves promising performance they will struggle to achieve, and accepting performance fee arrangements that are overly advantageous to the client.”
Some exponents of performance fees suggest that the additional financial incentive to perform might make managers try harder and be more conscious of how the investment decisions taken on the fund translate through to performance. But this could lead to an unwelcome increase in risk. A manager running a mandate that was subject to a performance fee might feel subliminally that he was expected to take more risk, and push as hard as possible against the risk limits. As Andrew Smith, partner at B&W Deloitte, comments “the manager is effectively long a call option on his own performance and has an incentive to take higher risks throughout the life of the mandate.”
A manager might also change the running of the fund in reflection of performance to date. If a mandate was structured with set targets over certain periods and performance looked set to fall short, the manager might start taking bigger bets to try and make up lost ground. Alternatively, a manager might try and lock in good early performance by shutting down risk. Fears of ‘fee management’ rather than fund management will encourage closer monitoring of the manager’s trading activity. As Hutton warns, “the additional policing required to ensure the performance fee arrangement is not influencing the way the fund is run will increase tension in the manager-client relationship.”
Structuring a performance fee with sufficient care to avoid these types of conflicts can be an onerous process. Key inputs are the discount to the standard fee, the percentage of performance to be paid over to the manager and the hurdle over and above which performance fees will be charged. The formula should account for periodicity in returns and include some means of retaining fees in case performance dips. Gary Dowsett, investment consultant at Watson Wyatt, suggests a longer term calculation of the performance fee, rather than annual, and staggered annual payments so that the client does not pay for performance which is subsequently lost.
Smith reveals that some mandates with performance fees rebase annually, giving the manager who has underperformed the opportunity to earn performance fees for bringing performance back to the benchmark. Smith recommends incorporating some element of clawback to avoid paying managers for recapturing lost performance and to discourage excessive risk taking.
Pension plans may well be happy to pay managers more if the fund has achieved absolute returns. But a conflict could result from having to pay performance fees if the manager has secured performance in excess of the benchmark, but has still lost money. As Derbyshire, comments, “in this instance, the fund can ill afford to pay higher fees, even though the manager has outperformed.”
Concerned that performance fees might lead to managers taking on too much, or indeed, not enough risk, Hutton is more likely to consider a performance fee in the case of a highly quantitative product where there is less scope for human intervention either in terms of the investment process or the level of risk. Dowsett sees a particular role for performance fees in the arena of mandates such as enhanced indexation, which use low risk techniques for adding performance. Comments Dowsett, “the manager running a high risk portfolio needs no additional encouragement to take risk.”
Managers who are confident of performing well will be more than happy to consider performance fees, on the expectation of increasing their income. Typically a manager will halve the flat fee and expect to take anywhere between 15% and 25% of performance above the performance target. Mark Archer, marketing director at Allianz Dresdner Asset management comments, “should we meet the return target we would expect the total fee to be equal to our standard fee, with performance of double the target effectively doubling the standard fee.” However, few managers would want to move wholesale to a performance fee arrangement, because of the additional volatility of earnings it brings. Archer postulated a figure of 25% of total fee income reliant on performance as a maximum.
Kanesh Lakhani, marketing director at State Street Global Advisors, suggests that the base fee should be sufficient to cover costs and to ensure that the business continues to operate when a performance fee is not earned. Typically State Street performance arrangements include a high water mark of cumulative excess return, so that if the manager gives back some performance already achieved, the fund has to regain that position before the manager can earn more performance fees. Lakhani sees interest from about 20% of clients in performance fees but expects this proportion to increase. Lakhani says: “At the end of the day if a client is not confident about a manager’s ability to outperform the manager should not be hired – the fee basis becomes a secondary issue.”
For trustees, it is easier to justify high fees if managers have outperformed and difficult to defend paying for active management if performance is below the benchmark. But for Hutton, the appropriate response to weak performance is to fire the manager, not to pay less. However, it is a longer and more drawn-out process for a pension fund to fire a manager than a multi-manager fund. Maybe the root cause of the problem is not the level of fees but the speed with which pension plans fire underperforming managers. Possibly performance fees act as an analgesic to poor manager selection, so that trustees at least have one positive thing to report if performance is disappointing, and some comfort that the underperforming manager is sharing some of the pain.