Fund manager fees – what you should know

While most prudent investors would agree that incentivising their fund managers to produce market-beating results is a good thing, those same investors would also be within their rights to demand that fees are reasonable and earned.

In South Africa, fund management is regulated by the Financial Services Conduct Authority (FSCA) and the Prudential Authority (located within the South African Reserve Bank). These authorities oversee the financial soundness and market conduct of financial institutions, including fund managers.

Clients investing in portfolios managed by asset managers pay the manager a basic or fixed fee. This is remuneration earned for managing a portfolio. In addition to earning fixed fees, the underlying managers of certain portfolios may also earn performance-based fees. Performance bonuses can be manipulated, and investors need to be aware of how they are set and calculated.

Fund managers’ performance fees can be defined as additional fees that reward a fund manager for outperforming a predefined benchmark, plus a hurdle rate. Performance fees are therefore designed to reward an active manager’s skill in generating outstanding returns. Methods of manipulating fees include setting the benchmark at a level that is too low and thus easily achieved, or by not setting an appropriate hurdle rate. The hurdle rate is the amount by which managers need to exceed the performance-fee benchmark before they start earning performance fees.

In order to establish the reasonability of the hurdle rate, an investor should ask whether the set benchmark equals the performance of, for example, the JSE All-Share Index (Alsi), or whether it is set at a level above performance of the Alsi. For example, inflation-based benchmarks are currently easier to outperform, as the economy has been operating in a low-inflation environment.

Fees can also be manipulated by not setting a cap — capping the outperformance of the performance hurdle, after which no further performance fees are paid, or by setting a cap that would only be triggered once the manager has outperformed the Alsi by 10%, which is unlikely. By manipulating performance fees, fund managers can double or even triple the fees that they receive from investors. Caps are instituted purely to limit fees to an acceptable level. Uncapped fees, by definition, can result in limitless fees. In the prudential environment of pension fund management, where a combination of capital growth and preservation is often required, an argument can be made for capped fees to limit needless risk-taking in the pursuit of performance fees.

Another principle that an investor should be aware of is ‘high watermarks’. High watermarks ensure that a manager does not earn performance fees unless the investment is generating new performance above the highest previously achieved watermark. This prevents clients paying for performance more than once where managers go through out- and underperformance cycles.

An investor also needs to acquaint him or herself with the period over which the manager’s performance is measured against the performance hurdle. While performance is generally measured over a period of rolling years in order to ensure that the measurement is sustainable and reasonable, this method of calculation may also lead to an investor paying fees for a performance from which he/she did not benefit. In many investment products, performance fees are calculated over a 12/24-month rolling period, payable monthly or annually. Ideally, measurement periods should be calculated over longer periods, in alignment with the fund’s stated long-term objective, and not reward managers for short-term performance, as it is difficult to determine whether short-term performance is as a result of luck or skill.

Due to the nature of the portfolios, managers may earn performance fees on a range of different benchmarks. Depending on the type of benchmark used, an investor should be mindful of the following:

For an inflation benchmark, performance fees should be capped, since managers may be rewarded in periods where equity markets have yielded high returns in a low-inflation environment.
For peer- or index-based benchmarks, an investor should ensure that these benchmarks are appropriate for the specific fund.
A performance fee should also be compared to other, similar funds as a check for reasonability; for example, the Total Expense Ratio (TER) should be in line with other, similar funds in the same sector.

The TER is the global standard in measuring the impact of costs on the value of an investment. The TER calculations of unit trusts normally include asset management fees, performance fees, as well as the costs incurred in the management of the portfolio, such as custodian and trustee fees, trading costs and audit fees, as well as VAT.

Most products offer investors both a flat-fee option and a performance-fee option. Flat fees provide more certainty for the investor, since the fee is always the same; however, a performance option usually has a lower base fee, so the investor may pay less when the fund underperforms. As a rough guide, the performance-fee option would be preferable if some or all of the following conditions are met:

the fee for benchmark performance is lower than the flat-fee option;
the maximum performance fee is capped;
the fee hurdle rate is in line with the benchmark of the fund, as well as those of similar peer group funds; and
the fee reduces when the manager underperforms the benchmark.

In most cases the products are generally the same, but the business model of how the asset managers are remunerated differs. The base fee should be lower than for fixed-fee products, as the asset managers could potentially earn attractive levels of additional fees, should they meet their benchmark/hurdle targets. It is also important to consider the merits of each, as you can align the interests of the client and the manager when calculating a performance fee over a longer measuring period. Then again, if the portfolio is not meant to allow for excessive active management, there should not be a need for a performance fee.

The information contained in this article is of a general nature and intended for information purposes only. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial, legal or other issue. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner/adviser to take into account your particular investment objectives, financial situation and individual needs.