The fee factor

Fund managers’ charges have become a significant cost for investors



THE SUCCESS OF ETFs (exchange traded funds) largely reflects their low cost. Where-as an actively managed share fund is likely to charge around 1.5%pa, most equivalent ETFs charge around 0.5%. This often understates the savings offered by ETFs, because a significant number of actively managed share funds also charge performance fees.

“Performance fees were initiated by hedge funds but have spread and are gradually gaining more acceptance among advisers and investors,” says Aman Ramrakha, executive manager (research) with CBA Wealth Management Advice. Fees can be as high as 30% of any return in excess of a specified benchmark, often simply the S&P/ASX 200 or S&P/ASX 300. “Fortunately the fee is often lower than this, usually around 15% to 20%, but it still has the potential to cut into an investor’s net return,” says Ramrakha.

Investors should not automatically avoid funds that charge performance fees. If they deliver, these funds should generate a higher return, even after fees, than their ETF rivals. But as Assyat David, a director of research group Strategy Steps, says, there is no guarantee the promise will be met. And if it is, the cost may have been greater investment risk.

“This is certainly a possibility investors need to be aware of, but opting for a fund that has a performance fee can still make sense as it definitely has the potential to deliver a higher return,” says Ramrakha.

The key challenge is to assess whether a fund’s fee is fair and reasonable – and, equally important, whether it is an appropriate incentive for the manager. At the very least you need to take the trouble to understand precisely how a fund’s performance fee is structured.

Just how complex this issue can be and how carefully it needs to be assessed has been highlighted by research group Morningstar.

In a comprehensive report in 2011, Best Practices in Managed Fund Performance Fees, Morningstar noted that just over 20% of the large-cap Australian share funds reviewed charged a performance fee.

“The analysis put forward in the report remains equally valid today, although it did prompt a few funds to improve the structure of their performance fees,” says research manager with Morningstar, Tom Whitelaw. As he explains, while the report didn’t focus on the fee structure of each fund, it did identify six key performance fee issues:

• The size of the fee.

• The benchmark against which the fund’s performance is measured.

• Whether there is a hurdle that has to be reached above the benchmark before a fee is paid and what that hurdle is.

• Whether there is a so-called high-water mark, and how it is structured.

• What right a fund manager has to reset the high-water mark.

• The period over which the fee is calculated.

The vast bulk of the funds surveyed set the performance fee at between 15% and 20% of any so-called outperformance. One, however, set it at 25% while another charged a huge 30%.

In the case of the benchmark, one manager paid itself a performance fee merely if it achieved a return greater than zero. Fortunately this is highly unusual and the rest benchmarked against either the S&P/ASX 200 Accumulation Index or S&P/ASX 300 Accumulation Index.

Nearly all imposed a performance hurdle. In some cases the benchmark had to be beaten by 3% before a performance fee was paid. “The existence of an appropriate hurdle is essential,” says David. “Investors should definitely check on whether it is set high enough to ensure any performance fee is paid only when they receive good returns.”

Another important consideration is whether a fund has a so-called high-water mark provision that requires it to recover any previous underperformance before it can charge a performance fee. Of the funds surveyed, only two didn’t include this sort of provision.

“A fund shouldn’t be able to charge a performance fee until it has recovered any previous underperformance,” says Ramrakha.

However, almost half the funds with high-water marks gave themselves the right to reset after three years, in effect giving the manager the right to start charging a performance fee again even if the fund hadn’t recovered all previous underperformance.

Finally, investors need to look at how often a fund can crystallise performance fees, that is, pay the fee to the manager. As both Whitelaw and David note, a short period – say, less than a year – can encourage a manager to take an overly short-term approach to investing.

It can also result in a performance fee being paid after one good three-month period, even if subsequent quarters are much less impressive. Morningstar argues the crystallisation period should be a minimum of one year.

The challenge for investors is that, in the absence of clear regulations, the approach taken towards the six key performance fee parameters often varies significantly. The resulting complexity makes assessing and comparing performance fees more difficult than it should be.


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