Are performance fees on your investments ever justifiable?

Several of the larger South African Asset Managers persist with the practice of charging performance fees over and above their base fee for constructing and managing their funds. It is my opinion that this is an unfair practice for many reasons.

  • The benchmarks used are often not aligned with client objectives. Financial advisors will do financial modelling with their clients based upon Inflation + targets (e.g. CPI + 4% per annum over rolling 4-year periods). When markets are thriving, the selected benchmarks will often exceed the inflation + targets but when markets are struggling (as they have been over the past 5 years in South Africa) even if the Asset Manager beats their selected benchmark, the client’s objective may not have been reached. Importantly the benchmarks used to test for so called outperformance often do not align with the client goals. Using the ‘peer group average’ is hardly a measure of ‘out performance’ by any stretch and is simply a poor benchmark.
  • The concept of mean reversion over time. Mean reversion is a fancy term used in financial circles which basically means that things will generally revert to the norm over time. Therefore, when markets underperform, if economic cycles remain in play, then the returns during that period will be below the average expected. Similarly, when markets outperform, then the returns exceed those of the expected average. Measured over a relevant period, the returns an investor can expect will be the average of all periods.
  • Given that Asset Managers charge a base fee, the principle of marginal reward comes into play when they experience inflows without having to employ any additional expenses against the increased income. To illustrate, lets assume that an Asset Manager has an equity portfolio which charges a base fee of 0.75% per annum on assets under management. At the beginning of the period, they have assets under management in the fund of R1 billion. They earn fees of R7,5 million per year or R625,000 per month. Assuming their performance relative to their peers based upon their processes and ability is consistently in the top quartile of funds over 3, 6 and 12 months as a result of which, their assets under management grow by 15% to R1,15 billion Rand. Their fees earned increase to R8.625 million per annum or R718,750 per month. They have not had to incur any additional expenditure in doing their work, yet they have been rewarded for their performance due to increases in assets under management. Further, their positive performance should attract new business flows in addition to their growth in assets under management from existing investors, generating further fees on the new assets under management. For them to charge a performance fee over and above the base fee means that they are doubly rewarded but at the expense of the investor.
  • Fees matter in 2 ways.
    • The higher the fees charged against the investor’s account, the lower his or her effective return will be. Mathematically this makes a huge difference over time due to the power of compounding.
    • Investment managers who are skilled, client centric and use repeatable and proven processes deserve to charge a reasonable fee for the incredibly complex work they do. When markets are difficult, the best Investment managers arguably deserve the fees they charge more than at other times in the Investment cycles when the going is tough.
    • The table below illustrates the point clearly

  • Investors enter and exit the investment portfolios at different times and with varying rates of contribution. Too often, the attempt by Asset managers to smooth their performance fees over time using historical variables means that new or exiting investors could be compromised or preferred. There is too much luck in the process.
  • Institutional Investors seldom if ever accept performance fees and the Asset managers create special fee classes to accommodate this refusal. Why then should retail investors or smaller investment houses be charged performance fees? The work done is identical, but the Institutional investors pay materially lower fees.
  • Formulas used to calculate performance fees are often convoluted and misunderstood.

 

One might ask whether there are under circumstances under which an Asset manager could justify charging performance fees? Generally speaking, in the retail market where Financial Advisors represent the interests of their clients as investors, the answer would be a resounding NO!

My only concession might be if Asset Manager uses a benchmark of the higher of the Inflation + target of the investor after fees and the investment benchmark used over relevant rolling periods. This however would be extremely complex and so again I must voice my scepticism.

For the record, the Wealth Associates Asset Management investment committee will not include asset managers who charge a performance fee and despite many academic debates over the years with managers who try to defend the practice, none have succeeded in persuading me.

Perhaps I lack their intellect 😊

 

Jeremy Squier, Certified Financial Planner, Wealth Associates Bespoke Solutions.