KEY POINTS:
With global equities after inflation having gone nowhere in the past 10 years, it's not surprising that institutional investors are looking more closely at the extent to which fund managers are rewarded.
Fees are obviously important, but intelligent discussion on the subject in New Zealand hit a
low point some years ago when one "fund manager of the year" argued that management fees didn't impact performance. Yeah, right.
In recent times, one of the key developments in manager remuneration has been the advent of performance fees, whereby, if fund managers outperform, they get rewarded with higher management fees.
With a bit of spin, this development has been sold as a good deal for investors and fund managers. But a new report by accounting firm Grant Thornton, in Britain, raises a few questions about performance fees.
Performance fees are becoming more common locally too. But, ominously, the impetus for change seems to be coming from fund managers rather than investors. Whatever your view, Mum and Dad investors are increasingly subject to these sort of fees, so some background on the topic may be useful.
The GT report is based on a study of 240 listed UK investment trusts with about £15 billion ($40 billion) in funds under management. UK listed investment trusts are popular with New Zealand investors and a number are listed on the NZX. More than 45 per cent of the funds in the study had a performance fee arrangement.
Perhaps the most significant finding of the GT study was that performance fees did not lead to an improvement in a fund's performance but, instead, did lead to higher fees.
While this finding would probably surprise our "fund manager of the year", it shouldn't come as a bombshell to anyone who can master addition or subtraction: performance fees generally mean higher fees and higher fees logically lead to lower returns after fees.
Common sense reaches the same conclusion: fund managers locally and overseas probably aren't lobbying for the introduction of performance fees in the expectation that they will get paid less.
One of the key conclusions of the GT report was: "The study analysed the relative performance of 20 per cent of the sample over the five-year period 2003 to 2007 and found that, on average, funds without performance fees perform slightly better than those with performance fees."
No matter the impact on returns, performance fees are becoming increasingly the standard these days for actively managed funds (which, incidentally, makes index funds look that much more attractive), so it is essential that retail investors understand them and ensure that, if they are introduced, their introduction is done properly and fairly.
One of the key parameters involved is the selection of the benchmark against which performance is measured.
How performance fees work usually is that the performance of the fund is compared with that of an appropriate benchmark - an international share fund would be compared with the MSCI World Index of international shares; a technology's fund might be compared with the Nasdaq technology index; and a local bond fund could have a NZX bond index for comparison.
The amount by which the fund outperformed the index is calculated and the fund manager typically receive 5 per cent or 10 per cent of this amount.
The benchmark choice is critical - specify the benchmark wrongly and you might pay the fund manager too little or, more likely, too much. In most cases the amount payable is capped - for example, the New Zealand-listed City of London Investment Trust's performance fee is 10 per cent of the outperformance of a customised equity benchmark with a cap of 0.5 per cent.
Of the funds in the study, 65 per cent had a fee cap and most of those that didn't were absolute return funds. The GT study found that most of the performance fee structures in place "rewarded relative returns"; that is, the value added by the fund manager above that of the benchmark.
The study added "performance fees need to be devised so that they pay managers for their value added through stock selection or asset allocation and do not simply reward them for the strength of the market".
This latter issue is important because as we shall see in my next column, if you don't give a lot of thought to benchmark specification, you risk paying your manager a great deal of money in a good year for just doing as well as the market and despite poor absolute performance in other years.
We will also look at some examples of arrangements in the local managed fund scene having regard to some of the recommendations of the GT report. A copy of the report is available by contacting brent@cpam.co.nz.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
