Fees And Expenses
Shareholders want to get the most out of investments and good managers make an enormous difference to long-term returns. Consistent outperformance can make even the most expensive fees look like good value. However, high fees can bite hard into returns, especially when compounded.
As for most people, pay plays an important part in the motivation for asset managers. That said, some managers are paid too much. Managers who can make multimillions seemingly by turning up and collecting the annual management charge may have little incentive to take risks on your behalf. Investors should be sure that managers have reasonable and appropriate incentives structured in a way that leads them to add genuine value.
Some investment companies manage their own investments. These are commonly called self-managed funds. A majority hire an external manager. There is no standard way of working out the management fee but these are some of the most common mechanisms:
Some managers work for a flat fee, say £250,000 a year. In practice, flat fee arrangements tend to be applied only by self-managed investment companies. Fees at least partly linked to fund size give managers an incentive to make funds bigger by performing well. Percentage fees also penalise managers for going backwards.
Most fees are charged as a percentage of the size of the fund but “size” can be measured in different ways.
Size may be defined as net asset value (NAV) or the market capitalisation (the share price multiplied by the number of shares in issue). Market capitalisation defined definitions of size give an incentive to reduce or eliminate NAV discounts while adding to fees if shares trade at a premium to NAV.
Most fees are based on net assets but some fees are based on gross assets (net assets plus debt). Gross asset definitions of size may work badly for investors because it gives the investment manager an incentive to borrow money, increasing risk.
Some fees are tiered. Higher fees are charged on, for example, the first £100 million of assets, a lower fee on the next £100 million and so on.
Some management contracts mix a basic percentage with additional fees payable relative to investment performance. Performance fees sometimes attract bad press but that is usually because the contracts have been badly thought out. Whether by accident or design some managers have walked away with enormous sums of money for having just one good year, sometimes without even beating any benchmark. Designing a good performance fee is all about aligning managers’ and shareholders’ interests.
“Whether by accident or design, some managers have walked away with enormous sums of money…
Performance fees are usually calculated with reference to a benchmark or a hurdle. Among many others, this could an index, a peer group average or set relative to the rate of return of an investment with low risk of financial loss. Rates of inflation may also be used. A few funds, mainly hedge funds and private equity funds, get performance fees just for making profits; some people think this is setting the bar too low.
Ideally performance fees may only be earned if the NAV has risen since the last time a fee was paid (this is referred to as the high watermark). Funds that invest in volatile assets can alternate between very good and bad years. If managers earn a performance fee for good years, but fail to suffer commensurately in worse years, shareholders can find themselves paying performance fees over the longer term even if NAV drifts sideways or falls.
You need to ensure that the right people are being motivated. Ideally boards should ensure that the majority, or even maybe all, of a performance fee gets paid to the people that generated the outperformance.
Good performance fees should encourage long-term thinking because most investors have long-term value horizons. One way to align managers’ and shareholders’ interests is to pay performance fees in shares in the fund rather than cash. These work best if the share-based payments cannot be sold for a number of years. Variations might include clawback arrangements triggered by subsequent underperformance, or fees that are earned over multi-year periods.
Fees paid by investors cover more than individual managers’ remuneration. The ongoing charges ratio measures all the ongoing running costs of a fund relative to market capitalisation or average net assets. Running costs include bank charges, fees for directors, lawyers and custodians, marketing costs, stock exchange listing fees and other administrative expenses. QuotedData uses the current-year charges and the average NAV in the comparable period. QuotedData displays these as a number, expressed as a percentage, within the sector data tables.
Usually performance fees are excluded from the ongoing charges ratio calculation, because they are by nature one-off items, but some sources will quote two ratios, one excluding and one including performance fees.