Fund managers who levy exorbitant charges when they beat certain benchmarks are coming under pressure to ensure their fee structure is fair for investors.

As well as making investors pay an annual ongoing charge to cover things like administrative costs and the fund manager’s salary, some funds charge a performance fee. Typically ranging from 10% to 20%, investors have to pay this fee if the fund beats a specified benchmark.

For example, Polar Capital Global Technology Fund (IE00B42W4J83) charges 10% of the amount it outperforms the Dow Jones World Technology Index, and Old Mutual Global Equity Absolute Return Fund (IE00BLP5S809) charges 20% of the amount it outperforms the Bank of England base rate.

WHY HAVE PERFORMANCE FEES COME UNDER FIRE?

The regulator, the Financial Conduct Authority (FCA), recently expressed concerns about the way performance fees are levied, particularly in the absolute return sector which is home to the Old Mutual fund.

The FCA said some absolute return funds charge a performance fee even when the returns are lower than the fund’s most ambitious performance target.

‘This leads to the manager being rewarded despite not achieving what the investor considers to be the target performance,’ the FCA said.

WHY IS IT A PROBLEM IN ABSOLUTE RETURNS FUNDS?

The absolute return sector has been targeted because it uses performance fees to a greater extent than other sectors.

Patrick Connolly, head of communications at financial advice firm Chase de Vere, argues that very few funds in the sector can justify taking a performance fee.

He says many funds produce returns similar to cash but with much higher charges. Others are too highly correlated with the stock market.

Connolly claims inappropriate benchmarks such as the Libor rate (currently around 0.5%) mean many cash savings accounts could qualify for a performance fee if they were placed in the targeted absolute return sector.

HOW ARE MANAGERS INCENTIVISED?

It isn’t just the absolute return sector where performance fees have been condemned. Critics argue that managers should be incentivised by the ongoing charge alone. They say levying performance fees effectively forces investors to pay managers twice for doing their job well.

Investment companies claim performance fees ensure the interests of the fund manager and investor are closely aligned. But Connolly says this argument is largely without foundation.

‘The interests of managers and investors are aligned by the manager producing good and consistent performance, full stop. If this happens then their funds will grow in value, they will become more popular and more new money will be invested,’ he says.

It could even be argued that performance fees create a conflict of interest between the manager and investors. A manager might take additional risks to try to breach a performance fee threshold, or become more conservative to protect gains rather than trying to maximise future returns for investors.

WHAT IS THE DIFFERENCE?

Some investment companies point to their impressive track record to justify their performance fees. Polar Capital, for example, says its Global Technology Fund has outperformed its benchmark index by 97.45% net of all costs since its launch in October 2001.

But it’s important to realise that you could end up paying performance fees even if a fund has dropped in value. This is because it merely has to outperform the benchmark – i.e. not fall quite as badly as the benchmark.

Iain Evans, global head of distribution at Polar Capital, says: ‘It is possible for the fund manager to earn a performance fee in a year where the benchmark delivers a negative return, but only if he or she outperforms this benchmark over the performance fee period.’

Evans says other asset managers eschew performance fees for building scale on conventional annual management charge (AMC) revenues.

‘It is far too simplistic to argue one approach is better than the other and both can engender poor behaviours,’ he states.

A spokesperson for Old Mutual says its fund has a ‘high watermark’ – you only pay a fee for outperformance achieved above the highest published price for the share class across all previous investment periods. This means you won’t be charged a performance fee for gains made as the fund recuperates losses.

There is evidence to suggest performance fees can work in certain circumstances.

Darius McDermott, managing director at Chelsea Financial Services, says JO Hambro Capital Management has a lower than average AMC and a performance fee that is related to a fair benchmark. JOHCM UK Opportunities’ (GB00B95HP811) AMC is 0.63% (the ongoing charge is 0.7%) and it has a performance fee of 15% of any outperformance of the FTSE All Share.

‘They have been very successful in aligning themselves to investors and achieving good outcomes for investors in our view,’ says McDermott.

IS THERE ANOTHER WAY?

Dan Brocklebank, director at asset manager Orbis, says when performance fees are levied in addition to an ongoing charge it creates a ‘heads we win, tails you lose’ proposition for clients.

‘The manager stands to do pretty well (regardless of performance) on the base fee, and can do extremely well if they take both the base fee and a share of performance,’ he explains.

Orbis doesn’t charge a base fee. Fees are paid into a reserve at a rate of 50% of outperformance, which is then available for refunds at the same rate if the funds underperform.

‘By linking fees to actual performance delivered, and provided you structure the performance fees well, fees are much more likely to represent value for money for the client and risk is transferred back to the manager, or at least shared between the client and the manager,’ says Brocklebank.

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