Performance fees are in the spotlight, but will they work for active managers?
Fund managers are starting to rethink how they charge as big names take on the competition with new performance-linked models.
Last week, Fidelity International announced a radical move to a so-called fulcrum fee, igniting a debate on whether performance-aligned fees could be a solution for firms to win back trust as money managers.
Fidelity is one of the first household names to step forward with a contrarian model, hoping to steal a march on its rivals.
However, commentators have questioned whether Fidelity’s approach will really improve value for money or reduce complexity for investors, as a number of investment firms lower their own fund fees in response to regulatory pressure and the rise of passives.
Is it time for other fund managers to follow Fidelity by fundamentally shaking up their fee models, and will clients better trust a system that links how their investments perform with what their manager is paid?
Forward with a fulcrum fee
The basic idea behind a fulcrum fee is that the fund’s expenses will fluctuate based on its performance versus the benchmark. In some cases, funds have basic ETF-like fees that increase incrementally to a set maximum level when they outperform. However, Fidelity plans to refund investors part of their fee for underperformance while charging extra for outperformance.
The fulcrum fees from Fidelity will be introduced as a new share class available to retail and institutional investors. Fidelity says if the new charging model proves successful, it hopes to roll it out to other single-strategy funds, although it notes rolling it out to multi-asset funds would prove more complex.
Orbis Investments director Dan Brocklebank says Fidelity’s “positive” step is a reflection of the firm moving away from the “flawed” fee structure that persists among its peers.
He argues that current percentage-based charging wrongly incentivises growth and asset gathering.
Brocklebank says: “Most fundamentally [Fidelity’s move] shows that the rest of the industry is waking up to the fact that in the current model investors pay based on how much money they have with the firm rather than how well the fund manager does.”
Fidelity indicated it would use a 36-month period for evaluating performance when it made its announcement, in line with its American parent, which is already using the model.
Brocklebank says the three-year lookback period is not perfectly aligned for all investors, but assuming investors come in with a long enough horizon, this should not be an issue over the full investment cycle.
He adds that fulcrum fees are likely to be more stable and predictable than fee structures that are calculated over shorter time periods.
Orbis Investments applies a refundable performance fee, where if the funds beat the benchmark, 50 per cent of the outperformance is charged and put into a reserve.
In the case of underperformance, the fees in the reserve are refunded to the client in the same ratio. The firm does not have an ongoing charge for investors.
Orbis has applied this to the retail market since 2014.
Pilot Financial Planning
In principle I welcome the changes to fees. Managers selling alpha should put their money where their mouth is. The only stumbling block would be on the availability of funds charging performance fees on platforms. It would be interesting to see how platforms deal with that. Another thing is how fund managers will calculate the performance fee. Where do you set the bar, for example? If you reset that every quarter and the fund goes down the quarter before, then it has not made it anywhere near back to where clients had invested and the managers will still get the fee the next quarter.
Brocklebank says: “Most existing fund managers don’t use our model because they are not comfortable taking on the accountability. It’s a great business model to receive 1 per cent of assets under management, so if you have a business built around that why would you ever move away from it?”
Fidelity also said it will reduce its annual management charge, but clients will pay for research under Mifid II regulation coming in on 3 January.
But Nucleus chief customer officer Barry Neilson says a reduction in the ongoing charge figure, and not the AMC, would be a better indicator of value for money.
He says: “Reductions in fund AMCs, which many consider to be long overdue, will be good news for clients but can only really be judged within the context of the overall cost the client pays for asset management. It’s therefore the ongoing charges figure that is more relevant and should be used to establish value for money.
“Fund groups now have a fantastic incentive to innovate ways to better align the price paid by customers with the delivery of their required investment outcome. It is important, however, that this is done in a manner that avoids complexity and is easy for the client to understand.”
In its interim report into the asset management industry, the FCA has already pointed out some fund managers claimed their objective was to beat an “ambitious benchmark”, but charged a performance fee against a much lower target.
In a short note in its final report, published in June, the regulator renewed some concerns over firms charging performance fees and promised a further review into the rules.
The FCA says: “We are considering consulting on rules so that performance fees are only permitted above the fund’s most ambitious target. We also found some performance fees were charged on gross returns (before ongoing charges) and therefore we intend to consider whether performance fees should only be permitted above the fund’s most ambitious target after ongoing fees.”
Morningstar says Fidelity’s announcement was too scant on detail to determine whether the agency will need to review the relevant fund ratings.
However, Morningstar director of ratings Christopher Traulsen says the agency would “absolutely” review the ratings for any affected funds if there was a material impact to the investment case caused by the fee.
That also includes reviewing the parent rating for any firm that had taken a step to disadvantage investors.
Morningstar considers watermarks, performance awards, the evaluation period and appropriate benchmarks when assessing performance fees, with the latter three most relevant to the fulcrum fee model.
Traulsen says Morningstar will “shout about it loud and clear” if they see Fidelity adopting “easy” benchmarks. “If you’ve got a manager who’s going into lots of small and mid caps and is using the FTSE All Share or the FTSE 100, that could be a warning sign. A cash benchmark on anything other than a true absolute return fund is a warning sign.”
The industry is waking up to the fact that in the current model investors pay based on how much money they have with the firm rather than how well the fund manager does
Fidelity International is a distinct entity from the US company it spun out of, but Morningstar notes the Johnson family remains a significant shareholder. “It would not surprise me if they’re going to learn from the US experience and use a similar model, but without them having said anything or bothering to provide any details, we can’t really say.”
Morningstar says it prefers a lower all-in fee to performance models.
The FCA declined to comment further on performance fees.
Clues from America
In the US, the Investment Company Act of 1940 prohibits asset managers from using pure performance fees, but fulcrum fees are permitted.
The Morningstar database registers over 300 funds in the US using the fulcrum fee model with Fidelity Investments the asset manager that has used it the most.
A list compiled for Fund Strategy by Morningstar shows that around 60 per cent of the US funds in the database that charge a fulcrum fee are from Fidelity.
Janus Henderson is the next most prominent user with 32 funds listed, representing roughly £10bn assets under a fulcrum fee in the US.
Most Fidelity funds charge a performance fee of 0.2 per cent, which is for the most part higher than its peers.
The Clearbridge Large Cap fund’s performance fee is just 0.01 per cent, while Janus Henderson charges a 0.15 per cent fee and Pioneer charges 0.1 per cent. Several of Fidelity’s convertible securities funds, as well as the Telecom and Utilities fund charge a lower performance fee of 0.15 per cent.
Global asset manager AllianceBernstein recently offered a fulcrum fee system in the US, but claims this works differently than the one Fidelity will introduce.
AllianceBernstein head of global financial institutions Jose Cosio says so far the interest on its fulcrum fee from its distribution partners has been “overwhelmingly positive”.
He says: “We wanted to offer an innovative, competitive fee alternative to clients who are looking to benefit from active management. We are currently also in discussion with clients to assess the appetite for these funds in Europe, where initial responses have been equally encouraging”.
Fund Strategy contacted 18 UK asset managers to talk about their plans to potentially overhaul their fee system in the future. Four had responded at the time of writing.
One of these is Baillie Gifford. The Scottish asset manager has cut fund fees multiple times across various funds and started disclosing active share and turnover figures in defence of its active management.
In September, it slashed annual management charges by up to 10 basis points across its UK Oeics and Irish Ucits funds, covering a total of 20 funds. The firm does not charge performance fees and Baillie Gifford director of marketing and distribution James Budden does not think doing so represents value for money for clients.
He says: “Performance fees can come in all shapes and sizes and this can confuse investors as to what they are paying in total and how appropriate this might be in the context of the fund they are buying. Also performance fees can influence the investment approach of the manager.
“We have exemplified this approach several times this year already by reducing prices across our fund and trust range. We consider the appropriateness of fee levels in the context of fund scale, investment capacity, market competitiveness and ongoing fund costs.”
Vanguard believes the most effective way to reduce costs is to reduce fees but it has a version of symmetrical performance fees to incentivise the managers in its UK sub-advised active equities funds. However, while this influences the fees, investors only pay the upfront OCF.
After Fidelity’s shift this month, Standard Life Investments followed closely by cutting a chunk of fees, up to 30bps, on its flagship MyFolio multi-asset range. Notably, most funds in the range invest in SLI’s own funds.
Invesco Perpetual claims the company was one of the first groups in 2014 to launch OCF based charging to make it easier for investors to understand fund fees, and Old Mutual Global Investors managing director Warren Tonkinson argues the firm’s fixed charging model is already aligned to what the FCA wants from the industry in terms of transparency.
OMGI introduced fixed pricing to its UK fund range in 2015, meaning the fixed OCF is now made of an AMC and fixed expenses. Prior to this, the OCF could fluctuate slightly, as expenses weren’t fixed.
Demand for distribution
Novia Financial chief executive Bill Vasilieff says Fidelity has not gone as far as it could on the fees reform. He argues the only complication for platforms that include funds with a fulcrum fee would relate to disclosure.
Vasilieff says: “Fidelity doesn’t cut the charges down to zero if they underperform badly, and they said by their own admission they expect the overall charge to increase.
“From a platform point of view it should be easy to administrate, it’ll just be reflected in the unit price but the only complication comes when you are doing a projection of expected future benefits because do you include or exclude the performance fee then?”
Momentum Global Investment Management head of UK retail sales Andy Davies argues that it can be “very dangerous” if performance fees fail to align with what customers need.
He says: “When I ask IFAs if and what their clients know about benchmarks, no one put their hands up. If I was a client I would have wanted to know how much I am paying but I doubt any fund manager will say ‘you are going to pay a fee if we outperform’.
“The question here is, is the base case fee a fair representation of the minimum you have to charge to keep the fund running?”
Momentum owns Fidelity funds in its multi-asset range but doubts it will buy more of its funds with the new fee system.
AJ Bell head of fund selection Ryan Hughes, however, says any new fee structure will have to be judged on merit and says there should be no reason to exclude funds with these types of fees from the platform.