Introduced in 2004, performance-based fees have since established themselves as the ‘quid pro quo’ medium of exchange between investors and investment managers. While intentions of the pioneers of this thinking and philosophy may have been noble – incentivising managers to excel, greater net outcomes for investors, etc. – it painted much of the investment landscape grey, where unfortunately masterminds of the game have been allowed to skew outcomes in their favour.
Typically, equity managers in South Africa charge performance-based fees. This should simply imply that ought a manager outperform the portfolio’s benchmark, then the manager is entitled a performance-based fee. This is a sound concept, as one would expect that most would be happy to pay a little away in exchange for an above average return. History has shown us that when it comes to the application of performance-based fees, the devil is most certainly in the detail.
Before entering a relationship with an investment manager, one should determine how performance fees are applied.
Funds are usually classed according to how they are charged, i.e. Fund Class A charges a flat fee and Fund Class B charges a minimum base fee (which is sometimes 0%) plus a performance-based fee – typically the lower the base fee the higher the corresponding performance-based fee. While the higher flat fee structure may appear less attractive against the minimum base fee, as mentioned above the devil haunts the detail of how a manager applies a performance-based fee. The Association of Savings and Investments South Africa (ASISA) has published a set of recommended guidelines as to what constitutes fair practice with regards to performance-based fees, such as: capping charges, not charging for negative performance or the implementation of high-water marks – yet as these are not mandated, they remain only as guidelines. Currently portfolios that apply performance-based fees cannot be included in tax-free investment accounts, as they do not meet the transparency requirements set by National Treasury.
Factors investors should be aware of before entering into a performance-based fee agreement include investment hurdles, sharing ratios, high-water marks and benchmarks used.
1. Investment Hurdles
This is the level of performance a fund must achieve before the manager can charge a performance-based fee. This may be set as a percentage point, or two, above the performance of the benchmark. An example of this being should a manager outperform the ALSI by 2%, then the manager is entitled to share in this deemed outperformance. Issues of concern to investors include whether the manager’s performance, relative to the benchmark, is calculated net or gross of the base fee – this could make a significant difference to the ultimate return for an investor.
Another key consideration is how often do managers determine their respective performance-based fees. It’s not uncommon for a manager to have a fantastic, yet short lived purple patch that warrants the application of performance fee, yet a more justifiable application would be to measure portfolio returns against longer-term returns of the benchmark. An example of this is if the manager has demonstrated ability to beat the index plus the investment hurdle, net of fees, over rolling three-year periods, then the manager can more justly defend charging for outperformance.
2. Sharing Ratios
Sharing ratios refer to how much of the outperformance a manager is entitled to, this could be as much as 25% or more of outperformance – some managers cap fees, whilst others do not. Investors can safeguard their interests by determining if the cap to any fee structure applies only to the performance-based element or the total charge, that being the base fee plus the performance-based element.
3. High-Water Marks
Understanding high-water marks is essential when dealing with performance-based fees as their inclusion, or absence, will significantly influence investor returns. A high-water mark will record the highest performance, above the hurdle, that a manager has achieved. Ideally the high-water mark is immovable, meaning that performance-based fees may only be reapplied once the manager has exceeded the set high-water mark, often high-water marks carry a shelf life which is something extra investors should consider. ASISA’s guidelines recommend that performance-based fees only be re-introduced when performances are NET positive and when the portfolio’s high-water mark has been breached.
A benchmark is the yardstick used to compare the performance of a managed portfolio against. A well-known example of a benchmark is the All-Share Index (ALSI). Investors need to be mindful of which benchmarks are being used to determine outperformance, this is a grey area as the benchmark universe is scattered with near endless combinations of underlying asset class returns. ASISA recommends managers use only one benchmark of comparison and that managers should not alter the componentry of their respective benchmarks without due consultation with their investors.
A significant number of South African equity managers measure their performances against the JSE SWIX Capped index, and any performance-based fees are justified accordingly. Whilst this is accepted practice, it must be noted that the capped index limits weightings of individual holdings to 10%. The uncapped index is a truer reflection of actual pricing movements of the South African equity market. Whilst still a moving target, the limitations of the capped index allow for easier pricing forecasts and therefore more predictability versus the uncapped index.
A considerable other number of equity managers measure their performances against the sector average and apply performance-based fees accordingly.
The cold fact is that, according to the most recent biannual SPIVA report, 91% of local equity managers have been unable to beat the uncapped index over periods of five years or longer. This supports the inclusion of passive investment strategies (income trackers and ETFs) into a diversified portfolio, by doing so investors can purchase the market ‘capped’ or ‘uncapped’ at a fraction of the cost of a managed equity portfolio.
Conversely the SPIVA report shows that around 88% of managers in the fixed interest investment environment have been able to outperform their respective benchmarks, making it easier for investors to seek out market beaters.
Analysing a portfolio’s Total Expense Ratio (TER) history will provide useful information as to what the true costs of running any portfolio have been. Consumers have a right to know exactly what they are paying to make informed decisions, left unattended an investor could unknowingly pay double or even triple their expectations.