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Investment Strategy
Wednesday, April 1, 2009
Inside info..

Performance fees are a common topic discussed in the financial press. Many articles have been written debating the issues around such fees particularly whether they are fair for investors and which structures are most appropriate.

Rather than discussing the many different types of performance fees and how (and when) they are charged, “I thought it more pertinent to review some of the general issues of performance fees and see if these are still relevant today when we sit amidst the greatest financial crisis of our generation,” says Greg Flash of Alphen Asset Management.
In a Business Report article in May 2007, Vimal Chagan presented some of the pros and cons of performance fees which I summarise here:

Pros:
• Alignment of the fund manager and investor's interests - the investor benefits when fund manager outperforms (and hence earns more fees);
• The fund manager is more incentivised to generate outperformance than simply to gather more assets;
• Investors are happy to reward successful managers; and,
• Fund managers are focussed on their key role to generate performance.

Cons:
• Asset management firms experience more volatile income streams which can put pressure on them and their sustainability and hence raises the risk for the investor;
• Investors are often shocked by the fees that are reflected on their statements - buyer's remorse;
• Performance fees can result in the fund manager taking on unsuitable excess risk; and,
• Pricing errors can occur because of the complexity and differences of calculating performance fees.

At the 2007 ACI Financial Planners’ Forum performance fees were one of the hottest topics of discussion. Some of the key issues that were highlighted for investors to consider when looking at funds with performance fees included:
• Ensuring the suitability of the performance benchmarks and that they were not too low or easy to achieve;
• Performance fees should reward true manager performance and not luck or market performance;
• Performance fees are calculated on past performance and hence can and will be charged for some time after a fund has began to under perform;
• Performance fees are generally asymmetrical, i.e. attribute fees to the fund manager when they outperform but don't give them back when they underperform; while,
• Some funds have performance fees that are symmetrical, whereby they claw back fees for the investor during times of underperformance.

Flash says, “Many fund managers instituted performance fees during the previous roaring (and almost forgotten) bull market and investors were happy to pay them for those funds that performed well. In 2008 everything came crashing down and saw the ALSI have its second worst calendar year since 1926. According to Morningstar no equity fund in the Domestic General category has had a positive return for the past year (to 31st January 2009) and only one has had a positive return over the past two years.
“With these facts in mind investors may be horrified to know that they could still be paying large and in some cases maximum performance fees for some of the funds in which they are invested. This may seem terribly unfair for investors that have seen there capital dwindle.”
Investors should critically asses their investments and the fees they pay but should not forget the gains they have made previously and that their investments are generally for the long-term.
Flash adds that performance fees are meant to encourage a win-win situation for the fund manager and investor, however one has to remember what David Crosoer from Glacier Research said in 2006, "Almost always the fund manager has a better idea of the likelihood of his fund outperforming the benchmark than the investor. This informational asymmetry places the investor at a disadvantage when agreeing to an appropriate benchmark."

Copyright © Insurance Times and Investments® Vol:22.4 1st April, 2009
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