In a guidance note for the managers of KiwiSaver funds, issued in late May, the FMA advised the fund management industry of the criteria against which the FMA will assess the reasonableness of performance fees. The FMA believes performance fees need to be assessed on a case by case basis and its guiding principles are:
* it is reasonable to offer fair reward for investment management skills
* performance fees should reflect the risk taken by the investment manager and the investor.
The FMA looked at a number of aspects of performance fees including hurdle rates of return, high water mark, performance fee caps and benchmarks. Choosing which benchmark to use is particularly important and the FMA advised that the benchmark should be based on a suitable market related index.
The guidance note went on to say that fund managers should be paid for alpha not beta. What this means is that fund managers should not be rewarded just for the market going up, what they should be rewarded for is any value added above the performance of the appropriate benchmark index. This is all good common sense and consistent with what happens overseas.
In the past some fund managers have seen performance fees as something of a "get rich quick scheme". The road to riches typically involved introducing a performance fee element for the equity fund managed and ensuring that the performance was measured relative to a fixed interest benchmark plus a margin. For example fund manager XYZ might get 15 per cent of all gains that the fund it manages achieves above what 90 day bills have done plus 7 per cent.
This sounds reasonable because the stockmarket has outperformed 90 day bills by something like 7 per cent pa in the long term. But the reasonableness of that conclusion depends on a long term perspective. A performance fee however could become payable in the short term.
Remember that the stockmarket has a habit of flat-lining for a while then every five years or so goes up by 25 per cent or more. This column has previously reported on a local fund which has a similar performance fee and paid its manager performance fees of more than $7 million early in its life which wasn't a bad fee from a fund which started off with only $50 million in assets.
The point is that performance fee arrangements need to cater for "long tail" events, like the stockmarket rising sharply in a short period or 90 day bills falling below the rate of inflation, and the best way of ensuring that the interests of the fund manager and investors are looked after is to make sure the benchmark is consistent with the assets of the fund.
When the fund in question instituted its performance fee 90 day bills were around 6.0 per cent so 6 plus 7 equals a 13 per cent hurdle rate. Today with 90 day bills at 2.5 per cent and possibly headed toward zero the hurdle rate is just 9.5 per cent. Getting things right for NZ investors is not rocket science - perhaps all we need to do is copy what they do in the UK.
I highlighted the unfairness of mis-specified performance benchmarks as long ago as 2008, based on a report by UK accounting firm, Grant Thornton. One major conclusion of the Grant Thornton report was that understanding how performance fees work was often problematic so they urged fund managers to include a worked example so all investors would be fully aware of the implications of the fee.
The FMA needs to compel fund managers to do this also. I asked Elaine Campbell, Head of Compliance Monitoring at the FMA, whether this guidance would be extended to all managed funds and she said that "the FMA's responsibility only relates to KiwiSaver schemes, not to other managed funds and that extension beyond KiwiSaver is a policy question that would require legislative/regulatory change. I note that the MED is working on disclosure regulations".
That sounds like a "no" so it looks like NZ investors investing in managed funds other than KiwiSaver could be stuck with unsuitable performance fee arrangements for a bit longer. One of the worst performance fee arrangements I have ever seen afflicts investors in a certain infrastructure fund which I won't name.
This fund has a performance fee of 10 per cent of returns in excess of the cash rate. What that means is that the fund manager gets his/her base fee plus 10 per cent of returns that the fund generates in excess of 2.6 per cent. If we look at the portfolio of the fund we can roughly estimate that the dividend return of the fund before fees is going to be around 6 per cent - infrastructure companies invariably pay quite high dividends so the performance fee will be payable just from the dividend income of the fund.
No performance is required a buy and hold strategy would do the trick. What is more the pre-tax annual fees of the fund are a whopping 2.6 per cent pa and that excludes the performance fee. If this isn't bad enough the investment statement of the fund discloses fund costs after tax i.e. it reduces disclosed annual fees by about a third.
As this column has pointed out before the fund management industry must be the only business that quotes the after tax cost of its product given its tax deductibility. Imagine the uproar if Farmlands reduced the quoted price of gumboots by a third because the gumboots were tax deductible to farmers.
I spoke to the Ministry of Economic Development and they said "Under the Financial Markets Conduct Bill, disclosure statements will be redesigned to be clearer, shorter and more effective. For managed funds, this is likely to include more specific and comparable fee disclosure, including performance fees, than is currently required for investment statements.
The exact fee disclosure requirements will be considered when regulations are developed under the Financial Markets Conduct Bill. One potential example of disclosure is the presentation of worked examples, if it would aid investor understanding.
With respect to tax deductions in the disclosure of fees, we expect these to be consistent with the KiwiSaver requirements, which we anticipate will require disclosure of gross (before-tax) fees, rather than net (after-tax) fees. This proposed regulatory regime provides a balance between full and clear disclosure of fees, so that investors are fully informed, and the flexibility for fund managers to charge fees that they believe match their offerings.
The Financial Markets Conduct Bill is currently before the Commerce Select Committee, which is due to report back by 7 September 2012."
That sounds like very good news from the MED and the new laws should give the FMA more powers to do the right thing. It is of concern however that despite the FMA's comments that "fund managers should be paid for alpha not beta" they have deemed that some share funds with fixed interest benchmarks meet their suitability criteria based on expert advice. Maybe the expert in question wasn't aware of the history of performance fee payments in NZ, maybe the FMA needs to engage some new experts or better still, fire the experts, save the money and just do what they do in the UK.
In the meantime retail investors need to be on their guard and any who don't understand a performance fee arrangement adopted by any managed fund should simply avoid that fund and perhaps look at an index fund.
If the investing public start to appreciate the significance that mis-specified performance benchmarks could have on their returns it has the potential to further undermine confidence in local financial products. Fund managers run the risk of killing the goose that laid the golden egg - standard management fees on share funds of 1.5 per cent pa already take 15-25 per cent of prospective returns which is already far too high.