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.

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