William Flew on dodgy fees

April 11, 2011 § Leave a comment

Managers make millions while investors lose

Investment Performance fees are pushing up fund costs, with little return. William Flew reports

A growing number of unit and investment trusts are adding an extra layer to their charges, boosting the profits of fund management companies at the expense of private investors.

The charges come in the shape of performance fees, which are supposed to motivate fund managers, but critics say that they offer reward for failure.

In a recent study, Lipper, the fund research group, states that about half of all investment trusts operate a performance fee, including some of the biggest names in the sector, such as JPMorgan, F&C, Aberdeen and BlackRock.

Lipper also identified 88 unit trusts that have a performance fee in place. This is more than double the 34 in existence at the end of 2007. Among the major unit trust groups that levy performance fees are Gartmore, Jupiter, M&G, Neptune and Threadneedle.

The argument in favour of performance fees is that they give fund managers an extra motive to perform well. Ordinary investors reap the rewards of higher returns and the fund manager takes a slice of the enlarged cake.

Jason Hollands, of F&C, says: “Performance fees can help incentivise managers by aligning their interests with those of investors and encouraging them to beat a particular target.

“This is particularly true of absolute return funds, where typically the manager will be asked to meet a very specific target, rather than simply beating a moving index. Where the manager does beat a specific target, it seems perfectly reasonable for him or her to share in any excess return achieved.”

The problems start when trying to determine how this will be achieved. Someone has to decide which yardstick the fund manager will have to beat before being rewarded. In many cases, the yardstick seems to favour the management company and not the investor.

Lipper’s study shows that 66 per cent of funds benchmarking themselves against an index — such as the FTSE 100 — charge a performance fee even when they lose money for investors, as long as their fund has not fallen as steeply as the index.

An alternative approach — benchmarking against cash deposit rates — also has drawbacks. The Bank of England base rate is at the historically low level of 0.5 per cent, so if the cash target is base rate plus 3 per cent — a typical figure — this is a pretty modest target for an equity fund to achieve.

Equally, if a fund rises from, say, 100p to 150p this might trigger a performance fee. If the fund then falls back to 100p before bouncing back to 150p, triggering another performance fee, the fund manager would have been rewarded twice for covering the same ground.

To counter this criticism, some funds have what is known as a “high water mark”. This means that if a fund falls in value it must pass its previous high before further performance fees are charged. However, the Lipper study found that only 32 per cent of funds with a performance fee had a high water mark in place.

Advocates argue that performance fees align the interests of fund managers with those of investors. But this may not always be true. Justin Modray, of Candidmoney.com, the financial website, says: “Managers who get ahead of their benchmark early in a particular performance period may be tempted to sit on the gain until the period expires and they clock up their performance payment. Equally, managers who are behind their benchmark may take extra risk at the end of the timeframe to get back on their performance target.”

One question many investors want to know is how much will performance fees add to a fund’s existing charges? This is impossible to forecast because the size of the fee will depend on future



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