Should you pay fund managers 'performance' fees?
Should private investors pay fund managers 'performance' fees? One argument trotted out by the asset managers is that the practice aligns the interests of investors and fund managers because the latter have a greater incentive to perform well.
Unfortunately, there's no evidence to back this up. Indeed, it can be argued the carrot of a performance fee is an incentive to take more risks with other people's money.
New funds are often launched with performance fees attached in order to attract 'hedgies', supposedly hotshot hedge fund managers brought up on a diet of '2/20', where the annual management charge (AMC) is 2%, with a 20% fee payable on outperformance of a benchmark.
Whether or not they are justified, private investors must also factor in the reference benchmark that triggers the performance fee in the first place. An 'absolute return' fund that targets performance better than cash plus inflation, for example, could justifiably charge a fee linked to whether that target is exceeded.
So is it fair?
In my view, a fund such as Virgin Climate Change, which invests in environmental stocks, should link its performance fee purely to the sector it invests in, not the Bank of England base rate, which it sets as its derisory benchmark. Not only do you pay the managers 1.75% for the privilege of investing in what has been a poor performer, you pay them even more if they manage to exceed a 0.5% return.
Some funds do at least set a 'high water mark', whereby the next performance fee can't be triggered until the previous top net asset value has been beaten. Not all fund managers offer this protection, though, and you'll need to rifle through a fund's prospectus to find the terms.
For more on performance fees, read our recent interview with fund manager Anthony Bolton.
But two other facets of the performance fee debate really do rankle. One is that fund managers are not prepared to reduce the standing AMC to compensate for the performance fee. I'm calling for an AMC of 0.5 percentage points below the market average if such a fee is being charged.
What really makes my blood boil is that once a performance fee has been paid, there's no way to claw it back should subsequent performance be poor.
CF Octopus Absolute UK Equity was one of last year's top-performing funds, with a total expense ratio of 10% after the performance fee was levied. The fund has since fallen 20% - hardly a compelling advertisement for absolute return funds or performance fees - yet the managers will still collect an AMC of 1.5%.
I'd think carefully about investing in any fund that levies a performance fee. In 1939, the legendary Fats Waller recorded a song called You Can't Have Your Cake And Eat It. That's true for investors but, it seems, somewhat less so for fat cat fund managers.
Andrew Pitts is the editor of Moneywise's sister magazine Money Observer.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
A document which describes and advertises a new share issue or flotation (IPO in US) to potential investors, the contents of which are regulated by UK company law, the Financial Services Authority (FSA) and the London Stock Exchange. The prospectus should include details such as a description of the company’s business, financial statements, biographies of executives and directors, detailed information about their remuneration, any current litigation, a list of assets and other information deemed relevant for consideration by a prospective investor.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).