The ins and outs of performance fees

We write about fund costs a lot here at Morningstar, usually in terms of the total expense ratio (TER)--a standard way to evaluate ongoing fund costs. Costs are also a significant element of the Morningstar Qualitative Rating for funds (click here for an up-to-date list of ratings available for funds sold in the UK). We pay close attention to expenses for a simple reason: they are among the more important factors in determining relative fund performance. They chip away at performance year after year and their impact compounds through time.

The TER includes all standard operating costs with the exception of the transaction costs incurred by the fund manager to trade securities within the portfolio. However, they can also include performance fees that can make them substantially higher. That isn't necessarily bad, but it's worth having a closer look at the pros and cons of these additional charges:

What are performance fees?
Performance fees are contingent charges that are levied if a fund outperforms a specified benchmark or "hurdle rate". These fees are charged in addition to a fund’s annual management fee. To illustrate, let’s take a look at the “two-and-twenty” fee structure that is common in the hedge fund world. Under this system, these funds charge a 2% annual management fee and an additional 20% on any returns that exceed a specified hurdle rate. Although hedge funds have long charged performance fees, they are a relatively recent but growing phenomenon in the retail fund world.

We have mixed feeling about performance fees. If they are structured poorly, performance fees can reward a manager for failing to meet the minimum qualifications for his job. After all, active funds charge more than cheap index funds because they contend that they can beat the benchmark. So in some sense, the fund’s TER already includes a charge for assumed outperformance. (Never mind that the average manager has a tough time beating index funds, but that’s a subject for another article).

Still, charging an additional fee for outperformance doesn’t have to be a negative. If they are structured properly, performance fees can help better align a manager’s interest with his shareholders’, without allowing total fees to become unreasonable.

Best practices: the case for fulcrum fees
Ideally, we’d like performance fees to be structured as fulcrum fees. That is, fees should go up if a fund outperforms, but they should also go down by an equal proportion when the fund underperforms. A few countries, like Norway and the U.S., require fund companies to employ this symmetrical structure for performance fees. But unfortunately, these countries are the exception rather than the rule. The vast majority of performance fees only go one way – in the favour of the fund company. They get rewarded for outperformance, but there is no penalty for underperformance. Does that strike you as unfair? It does us. But sadly, it's the norm in Europe.

Best practices: below average "base" TERs
If a performance fee isn’t applied symmetrically then at the very least, the fund’s management fees should be below average. Otherwise, there is no risk at all to the fund company--they earn the full fee any active fund would even if they underperform. Moreover, a fund’s TER can become exceedingly burdensome. Consider Socgen International SICAV, a global large-cap blend fund, which charges a hefty management fee of 2.00% and then an additional performance fee of 10% on returns that exceed a hurdle rate of LIBOR plus 2% (there is no fulcrum). As a result, the fund’s TER comes to a whopping 2.96%, well above the category median of 1.63%.

Best practices: appropriate benchmarks are key
That fund’s hurdle rate also doesn’t meet the standard for reasonableness because it largely rewards the fund for the performance of an asset class (global equities), or beta. If it can beat a cash benchmark (LIBOR) by more than 2%, it gets a performance fee, even if the fund massively underperforms a relevant equity benchmark such as the MSCI World Index. A performance fee that will reward a manager even when he subtracts value is a poor proposition indeed.

Instead, performance fees should be structured to reward a fund for outperformance over its asset class. Thus, we’d rather see a fund’s performance measured against a benchmark that best represents the fund manager’s investible universe. For example, an all-cap UK fund that invests broadly across the UK universe might reasonably measure its performance against the FTSE All Share (although if it had a heavy mid/small-cap stake a custom benchmark with more emphasis on the FTSE 250 and FTSE Small Cap indices would be in order, as the All Share still has a very large-cap tilt). A performance fee should reference a benchmark that rewards a fund when its manager adds value not when inherent strategy biases are in favor.

Best practices: high-water marks
Performance fees should also incorporate high-water marks or a similar mechanism. High-water marks refer to a requirement that a performance fee won’t kick in until the fund’s NAV exceeds its previous highest NAV. This prevents shareholders from paying performance fees on returns that represent the recovery of past periods of underperformance. For example, if a fund underperformed in 2008, shareholders shouldn’t be expected to pay a performance fee until the fund has regained the ground it lost. If a fund implements a performance fee without this requirement, it's a big neagive in our view.

Best practices: clear disclosure
Lastly, performance fees should be clearly disclosed and explained in fund literature. Investors should be able to easily locate and understand the explanation of the performance fees. Preferably, several scenarios will be provided to help investors understand how the performance fee might apply under a variety of market conditions.