Only 1% of open-ended funds charge a performance fee – but revenue uplifts in funds that do charge such fees underline the value of recognising and rewarding the skill of the manager.
Open-ended funds in Britain have been allowed to charge fees related to their performance since 2004, yet few have taken advantage of the change – only about 1% of retail investor-oriented unit trusts and Oeics.
Looking at Europe, the revenue uplift for cross-border funds that achieved a performance fee is 74%. This news is likely to encourage greater interest in performance fees. At the same time it is essential that the structure of performance fees balances the interests of all concerned: the fund manager, the fund company and the investor.
The change in regulations under the Financial Services Authority’s (FSA) Policy Statement 04/7 enabled open-ended funds to have a more level playing field with those in Europe and with British closed-ended funds (investment trusts) that were already able to charge such fees. Half of the latter (now known as investment companies) have a performance fee structure in place.
Before the change in regulations, open-ended funds were only able to reduce their management fee to simulate a traditional performance fee.
An early example of this was Portfolio Fund Management’s Performance Fund, launched in June 1996, which reduced its management fee from 1.75% to 1% for any month of underperformance. More recently a similar structure was used in Gartmore’s Focus Fund range.
Bedlam Asset Management provides useful examples of the difference between reducing a management fee and a traditional performance fee. This fund range offers an ‘A’ share class, where potentially a 5% annual management fee can be charged, however, this fee is only charged for any given quarter after the fund has generated an absolute return of 1.25% for that quarter.
In contrast, the newer ‘B’ share class can be chosen, which has a fixed annual management fee of 0.9% and a performance fee of 20% of net gains. The performance fee is only charged after the fund has both generated a return above a benchmark (in this case the three-month money market sterling deposit rate) and also beaten the fund’s highest quarter-end net asset value (NAV) (a high water mark).
The high water mark is a method by which a performance fee cannot be paid if a fund’s performance reflects a return to a previous high NAV – aiming to prevent shareholders from paying twice for the same increase in their fund’s share price.
Across Europe, our research into funds with performance fee structures has revealed that 47% have a high water mark in place (equity funds only). Of these funds, 73% have a high water mark that is permanent (that is, performance must reach an all-time high and so the high water mark is not re-set after a fixed period of time).
In addressing whether a high water mark should be permanent, a fund company will consider how de-motivating it might be for a fund manager if the fund’s share price were to languish well below a previous high. Spain’s Investment Law 35/2003 specifically states that the high water mark should be reset after three years of consecutive losses.
The FSA’s guidelines, which stipulated the requirement for a fund to earn performance fees only if it had generated positive returns was dropped between the consultation paper and final policy statement. As a result, a fee paid on performance relative to an index may be earned by outperforming that index over a period, even if the index (and the performance of the fund) is falling.
Separately, the policy statement states that “the prospectus should contain the maximum amount that the performance fee might represent in an annual accounting period” and that “this disclosure should be given in plain language together with examples of the operation of the performance fee.”
Both of these are crucial elements to help investors decide whether a fund with a performance fee might be suitable: how it works and how much extra you might pay.
The revenues generated by performance fee structures make their attraction for fund companies clearer. Across a universe of cross-border funds, the asset-weighted average management fee is 1.26%. The average performance fee charged for these same funds is 0.09%.
However, when we filter the universe to look only at those funds that charged a performance fee in the period, the average management fee is 1.35% and the average performance fee is 1.00%. This reveals a revenue uplift resulting from performance fees of 7%across the whole universe.
The use of performance fees varies across Europe. Research suggests that most of the major European fund markets have between 10-20% of funds with performance fee structures.
In America, a performance fee must have an upside and a downside; when the fund performs better than its benchmark, the bonus is positive; when the fund underperforms, there is a deduction from the bonus of the same percentage. This is what is known as a “fulcrum fee”.
Research from Lipper shows that the overall proportion of open-ended funds using fulcrum fees in America is just over 2%. Even among 130/30 funds in America, the only company to use fulcrum fees (RiverSource) also uses such a fee structure for many of its conventional mutual funds.
It is useful to look at whether the annual fees of funds with performance fee structures differ from those without performance fees. To create a reasonable and relevant sample, we have examined cross-border equity funds in Luxembourg and Ireland promoted by American and British fund companies.
In principle, fixed management fees should be lower for funds with a performance fee structure. In addition, some additional administrative costs incurred for funds with performance fees – potentially pushing up the total expense ratio (TER) should be expected (see table).
Indeed, the average management fee for those funds without a performance fee in place is higher than those with such a fee arrangement, by 14 basis points. However, among these funds, simple average TERs (before the impact of performance fees) are lower for funds without performance fees, although the levels are similar.
With the FSA’s comment that “charges should not be excessive when compared with the rest of the industry, which would also apply to any performance-related fee” (CP185), it is important that investors’ interests are borne in mind when structuring these fees.