Why fund managers still disagree about performance fees

Performance fees remain one of the most contested issues in fund management.

Managers in favour of performance-linked pricing say they better align the interests of investors and managers by linking fees to results.

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Some industry players argue they can be unclear, difficult to compare and, if poorly designed, allow managers to benefit more from good performance than they suffer from weak performance.

Coronation Fund Managers announced late last year that it would scrap performance fees on its remaining retail funds, moving entirely to fixed fees across its retail range.

Pieter Koekemoer, head of personal investments at Coronation, says the shift was driven mainly by investor and advisor demand for fees that are easier to understand, compare and budget for.

The complexity involved in measuring, disclosing and comparing variable-fee structures had become increasingly difficult to suit a broad retail market.

Moneyweb approached seven fund managers to find out how they deal with performance fees.

Concerns around performance fees are not new

In a 2006 paper presented to the Actuarial Society of South Africa, actuary Johan Schreuder examined how performance-based fees were being used in South African investment management, drawing on unit trusts, institutional mandates and public fee information.

He argued that fairness depends on how fees are constructed.

Factors such as the base fee, benchmark, fee cap, participation rate and measurement period can significantly change investor outcomes.

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A benchmark is the yardstick against which a fund’s returns are measured – typically a market index, inflation-linked target or peer benchmark.

Schreuder cautioned against using cash or inflation-linked hurdles for equity portfolios, saying these can reward managers for broad market movements rather than genuine skill.

He also highlighted the importance of longer measurement periods, fee caps and high-water marks – mechanisms that generally require managers to recover prior underperformance before charging new performance fees.

The debate continues

João Frasco of Stanlib Multi-Manager takes a similar view. He sees a place for performance fees, but only if the methodology is robust.

Some fee structures, he argues, use hurdles that are too easy to beat or lack fee caps.

They may also rely on rolling periods that can allow managers to charge more than once for effectively the same performance.

Sean Peche of Ranmore Fund Management began looking more closely at performance-fee structures after reviewing a client portfolio that layered performance fees in underlying balanced funds over and above advisor charges.

That has led to broader questions around benchmarks and disclosure of fee structures.

Peche questions the use of peer benchmarks, arguing that performance fees should ideally be measured against recognised, investable indices rather than internally constructed peer averages that vary across managers and fund classes.

In his view, inconsistent benchmarks make it harder for investors to tell whether managers are beating a meaningful target.

Peche is also critical of how some structures behave in practice.

Frequent crystallisation (the point at which a performance fee is actually locked in and charged) and rolling high-water marks, he argues, can result in managers taking fees during strong periods without a comparable reduction when performance weakens.

Coronation’s Koekemoer does not reject the idea that performance fees can improve alignment. He stresses though that well-designed performance fee structures are often very complex.

Measures for investor protection – such as fee discounts during underperformance, longer measurement periods, and detailed benchmarking – can make fee models difficult to evaluate and compare across fund managers.

The case for performance fees

Managers that use performance fees argue that when designed properly, they can create a fairer relationship between what investors pay and what managers deliver.

Performance fees generally combine a base fee – the standard annual charge for running a portfolio – with a variable element that rises or falls depending on performance.

Read: Risks beneath the index and the opportunities beyond

Shaun Duddy, who heads Allan Gray’s retail product development team, says performance fees can be a useful way to align investor and manager interests.

“But when it comes to alignment, the most important consideration is that the performance fee is symmetrical [moving up or down depending on performance].

“Any performance fee where you share on the upside, but on the downside you don’t share exactly the same – that results in a poor outcome.”

Siobhan Simpson, head of SA Unit Trusts at Ninety One, says the principle behind its performance-fee structures is straightforward: “Investors incur a higher fee when they have genuinely benefitted from our active management skills, and they pay a passive-like fee when performance matches or falls below the benchmark.”

Ninety One says benchmarks must be anchored to what funds are designed to achieve.

“This is a deliberate, philosophy-driven approach – the benchmark must reflect what the fund is actually trying to do for clients.”

Read: Satrix and Sygnia tracker fund fees compared

PSG Asset Management’s equity-focused funds charge performance fees only once a fee hurdle or high-water mark is exceeded. The base fee on these funds is also typically lower than on comparable classes without performance fees.

Preanka Naidoo, head of corporate investment solutions at Sanlam Investments Multi-Manager, says performance fees are charged by certain underlying asset managers, while Sanlam itself levies them only on hedge funds.

“These benchmarks are useful in demonstrating a manager’s skill and avoiding the practical challenges associated with constructing and maintaining an investable composite benchmark,” she says of recognised peer-relative benchmarks used in the multi-manager environment.

Sygnia says it does not use peer benchmarks, but uses high-water marks as a “great mechanism” to protect investors from excessive fees.

The case for simplicity

After years of using performance-linked fees, Coronation says simpler pricing has broader appeal in retail investing.

Koekemoer adds that performance fees may be theoretically fairer because fees rise or fall with outcomes.

But they also introduce layers of complexity – from benchmarks and measurement periods to high-water marks and fee calculations – that make comparisons difficult for investors and advisors.

Even though fixed fees can create periods of imperfect alignment, retail investors tend to benefit from pricing that is straightforward to understand, compare and monitor.

Markets remain competitive, he says, and managers that fail to justify their fees through performance will eventually face fee pressure or asset outflows.

Read: A fund with 6% fees?