The Problem with Performance Fees

On the surface performance fees seem to make a lot of sense. I think the sales pitch goes something like this, “We keep our annual fees low, but if we beat our investment objective then we take 10% extra. But you only pay if you beat the objective.”

Sounds perfectly reasonable, doesn’t it? It’s not.

There are several issues with performance, fees but perhaps the two largest are:

1. Perverse incentives for fund managers
2. It’s too expensive

For a start we must consider one of the axioms of investing: Investment return is compensation for investment risk.  If you want to make higher returns, you must take more risk.

In fact, when you look at the monthly returns of most investments (if you have enough of them) they look like a bell-shaped curve. The flatter the curve, the more often you have extreme events in the tails and generally higher average returns.

Now let’s consider how a fund that earns a performance fee is paid. Many funds, such as the Milford Income Fund, charge clients a 10% performance fee as long as the fund outperforms the investment objective. In the case of Milford, that’s the 90-day Bank Bill Index. It also charges an annual fee of 0.65%.

The current 90 day bank bill rate is 2.72%. Let’s see how this funds compensation changes as the return increases.

This is just another way of illustrating a simple fact – the fund gets paid much better if it takes more risk and consequently has higher returns.

But do I want to incentivise a fund manager to take more risk? Does the investor want the risk? More risk means a greater chance for loss. Is that appropriate? Is the investor taking that risk on purpose, or by default?

Investors bear the consequence of down-side risk, not the fund manager. The fund manager doesn’t have skin in the game. If returns go below the 90 day cash rate they don’t lower their 0.65% annual fee.

So in other words I’ve:

1. Incentivized the fund manager to take extra risk (while)
2. Leaving the investor to bear the downside risk alone (and)
3. Simultaneously asking investors to give away a significant portion of the upside.

Does that sound fair to you?

And what’s the hurdle for the “performance fee” in the case of the Milford Fixed Income Fund? It’s beating the 90 Day Bank Bill Rate. Investors purchasing a 90 Day Bank Bill are taking almost no risk. But investors in the Milford Income Fund (our example of a fund with a performance fee) have 31% of their assets in sub investment grade fixed interest (the best assumption for what they term “unrated”), 21% in shares, and 6% in NZ Listed property. The balance is in investment grade fixed income and cash. Investment grade fixed income can be anywhere from AAA to just above junk. While there is nothing wrong with those assets per se, they are collectively far, far, more risky than 90 Day Bank Bills.

So the investment objective of the fund is to exceed a bank bill rate with which it bears almost no similarity to in terms of risk.

In other words, this performance fee isn’t much of a performance fee at all. It’s simply built-in compensation for holding assets far riskier than bank bills. I’d say it’s almost impossible for this portfolio to not beat the 90 day bank bill rate, except in extraordinary markets. Giving a performance fee for doing so is like giving the All Blacks a huge pay rise for beating the Japanese in pool play. What an accomplishment!

I don’t want to make Milford out to be the only one charging these fees. Fisher Funds charges a performance fee for beating cash on their growth fund! A growth fund is generally all equity. Why is Fisher comparing a growth fund to cash? The fund actually says they “benchmark” themselves to cash. Cash is no benchmark for a concentrated fund of shares. Beyond that, Fisher charges approximately 1.25% annual fee, an entry fee of 1% if you’re going direct and a 10% performance fee for beating that tough cash benchmark. The performance fee is subject to a high-water mark, a small but meaningful concession.

How about a real performance fee? How about a fee for beating 90% of your peer group on a risk adjusted basis after all fees and taxes are taken into account? If you do that you can have some sugar.

Here’s another proposal.

1. A performance fee based on actually beating a relevant index, on a risk adjusted basis, after fees. This way, you only get rewarded for delivering value over and above what an investor could have gotten in a passively managed fund.
2. If the fund under-performs, all accumulated under-performance to the relevant index must be earned back before any performance fee gets paid. If the fund really messed up last year but did a bit better than their relevant index this year, the fund must pay the investors back first! No performance fee.
3. The performance fee is paid as units of the fund that must be invested for 5 years before they are collected. This way the manager has more skin in the game.
4. Those units can be transferred back to fund shareholders during that same 5 year period if the fund subsequently under-performs after initially out-performing.

Any takers?

At Bradley Nuttall Limited we select funds that are low cost, period! Time and again it’s been proven that costs are the number one indicator of investment returns after accounting for risk.

Morningstar Director of Mutual Fund Research Russel Kinnel observed: “In every single time period and data point tested, low-cost funds beat high-cost funds.”

(Russel Kinnel. “Fund Spy—How Fund Expense Ratios and Star Ratings Predict Success” Morningstar, August 9, 2010).

Not surprisingly, our fixed income funds range in cost from 0.30% to 0.45% with no performance fees.

We are not interested in paying more to a fund manager to reach for yield. As an investment adviser one our main responsibilities is to control risk in our portfolios. This means we need to understand the exact nature of the risks fund managers undertake and ensure they are not increasing risk beyond their mandates. This is how we can ensure clients are in portfolios appropriate for both their financial goals and income needs.

Ben is General Manager at Bradley Nuttall Ltd

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