Performance Fees – Don’t You Just Hate Them?

I mentioned in a previous blog post the result of a performance incentive fee for the manager at British Smaller Companies VCT (BSV) which resulted in total fees of 6.9% of net assets last year. Another similar example is that of Proven VCT (PVN) who managed to do even better at 8.8% of assets for the same reason.

This problem of excessive and perverse performance fees has recently been covered in the FCA’s “Asset Management Market Study” and in a very good article in the Financial Times yesterday (FTfm 10/7/2017 – headlined “High and confusing performance fees attacked”). The FT called the FCA report “a stinging attack on the performance fees charged by some UK fund managers”. They quoted Mark Dampier of Hargreaves Lansdown who said “You have to be careful with the great majority of performance fees. They are not transparent at all, and no one understands them”. He also questioned the alleged “alignment” with shareholders’ interests and said “They align the interests of the fund manager with their profits”. That’s certainly a quote worth remembering when looking at investment trusts and funds.

He is certainly right about no one understanding them. I have known trusts where the directors and managers had to revise the wording of the performance fee as disclosed because it produced “unexpected” results. Or trusts where the directors refused to disclose the wording of the performance fee in the agreement with the manager when I queried it, or refused to disclose the calculation when I queried the result.

Performance fees in trusts and funds are surely like incentive bonuses and LTIPs for company management – a way to ratchet up fees without the increase being immediately apparent. It’s only a few years later that the shareholders realise the true impact of such arrangements.

And what happens if the performance fees don’t produce what the manager expects? Well in VCTs what happens is that such a trust (which looks like a dog to investors also) tends to be merged with another VCT and as part of the “restructuring” the performance fee is rebased. So performance fees tend to be of “tails I win, heads you lose variety”. If the performance is achieved the manager gets a bonus which comes out of investor returns, but if the performance is negative then the bet is off. The investors suffer the negative performance but the manager still gets their “base” fee (typically a fixed percentage of net assets).

The FCA pointed out in their report that some UK funds even take a performance fee based on fund performance before all costs are applied such as trading charges. So a performance fee is paid not on real returns to investors but on inflated results. The FCA is going to look further at that issue.

The FT article also highlights some other peculiar and perverse examples of performance fees. For example funds that calculate a performance fee relative to an easy benchmark. One BNY Mellon fund pays a 10 per cent performance fee “on any returns the fund achieves above 3 -month Libor minus 0.125 per cent”. So to get a performance fee they only need to achieve a return of 0.175 per cent. Another version of the same fund could generate a performance fee even when it returns zero per cent! According to the FCA “Absolute Return” funds are a particular problem in this regard – they tend not to report performance against their relevant and published “target return”.

Other problematic examples given were funds who calculate performance fees that are not reduced by periods of negative performance. These are termed “asymmetric” fees in FCA jargon. In other words, the manager gets a performance fee in the good times, but does not suffer in the bad times. But the investors in the fund only get the net outcome. Or as Alan Miller of SCM Direct was quoted in the FT article as saying: “It does not stand up to any form of justice that you can charge a performance fee for not making the client any money”.

Whenever I speak at investment trust AGMs (and VCTs are a major problem area due to their high fees to begin with), the managers and company directors often defend performance fees on the basis that they incentivise the manager and hence improve performance. As I keep telling them, there is no evidence of this. The data shows that funds with performance fees do no better than those without – in fact the higher the fees the worse the final outcome for investors, as John Bogle has demonstrated.

In any case, a fixed fee provides a good incentive because, if the fund grows, the manager gets a bigger fee. Plus, if the fund demonstrates good performance, it is likely to attract more investors and hence grow in size which generates more fees. The FCA also pointed out that fees tend not to fall as the fund size grows, i.e. the manager get most of the benefit of economies of scale. And there is also the contrary incentive – if the manager consistently underperforms they are likely to be fired.

The claim that fund managers work harder because they see the goldmine in the distance from their strenuous efforts is simply a myth.

There is perhaps a particular justification for performance fees in VCTs because large dividend payments made by such trusts can mean the net asset value is held level or even falls. But designing a performance fee that covers that and does not generate very peculiar results in some circumstances is exceedingly difficult. Performance fees based on dividend payments can produce exceptionally odd results as we have seen in the past in the Quester/Spark VCT. Namely massive performance fees paid out while the trust is actually making losses.

There is one simple solution to these problems. Performance fees should be scrapped as some trusts have done of late – for example the Amati VCTs, Legal & General on three funds, in the JPMorgan Claverhouse Trust and in others.

Unfortunately the FCA has taken a weak approach to this problem – indeed a lot of their Asset Management Market Study could be seen as a damp squib with no immediate action promised, as other commentators have said. All they propose on the issue of performance fees is to consider further “policy action” to make “performance fee structures more equitable”. Can this be achieved and stop investors being hoodwinked by over complicated performance fees? I doubt it.

In the meantime, investors should vote with their feet. Namely buy trusts and funds without performance fees in preference to those that have them.

Roger Lawson (Twitter: @RogerWLawson )