Fund performance fees are a legacy of the hedge fund industry. They were frequently included as part of the fees hedge funds have traditionally charged investors.
The argument went – and still goes – that if a fund manager could beat his benchmark over a period of time, he should be allowed to keep a percentage of that gain as an additional fee on top of the fund’s annual management fee. In the hedge fund world, for many years, this was 20%, with a 2% annual management fee.
Many investors were happy with this, as they felt it incentivised the fund manager and his team to work harder. The money that they would be paid as a result, was from profits they were achieving as a result of beating their benchmark, or in many cases, their high-water mark.
What has changed is that, thanks to the success of that model, many large fund managers have started to include fund performance fees as part of the charging structure for retail funds, sold to private investors.
Guidelines for fund performance fees
Under European Union law, fund managers are obliged to provide investors with something called a Key Investor Information Document (KIID). This a document that is meant to clearly illustrate, in language understandable by a layman, what it is the fund does, what an investor should expect from a fund, and how and when a fund should be charging fees.
In its recent review of business practices within the UK asset management industry, the Financial Conduct Authority had a few things to say about the way fund managers were illustrating their fees, including fund performance fees:
• Some fund managers are claiming that they will seek to beat one benchmark, a more ambitious one, but their fund performance fees will be based on beating a much more prosaic one, for example a cash return rather than a stock market return;
• Many fund managers are also taking their fund performance fees before any other costs, rather than net of the cost of the day to day running of the fund. This is currently against FCA guidelines.
Across the funds industry, there are many funds which are being not clear how and when they will levy performance fees, or which benchmark they will be using. Recent research carried out by the Financial Times newspaper discovered a range of egregious cases, for example a fund managed by Insight Investments (Absolute Insight Fund) which in its KIID explains its objective is to deliver returns of cash plus 4%, while at the same time it will apply performance fees of 10% on returns above 3 month GBP Libor minus 0.125%. This would equate to a return of only 0.175% before the performance fee is triggered.
Some fund managers are deliberately vague about when the fund performance fee is levied. Again, for what could constitute quite a hefty part of the overall cost of the fund to shareholders, this fee should be very clear. Where it is clear, such statements are usually buried in the small print, and usually involve beating a cash rate, which is very low at the moment.
Protecting against excessive fund performance fees
Here are a few things investors should do about this. Remember, in many cases, managers are being issued guidelines by regulators – they are being told what they ought to do, not what they must do. There is a difference. The FCA may eventually be forced to make better reporting compulsory, but currently many poor practices are being hidden behind big brand names.
• Be aware of the total expense ratio (TER) of any fund before buying it – fees can quickly eat up any decent performance from a fund. The TER is the total cost of the fees you should be paying.
• Read the small print, not just the KIID. It is now obvious that fund managers feel they can add charges to the central documentation that are not included in the KIID.
• If you have questions, address them to your financial adviser, or indeed raise them on our forums. You should also contact the fund manager’s customer services team, but be prepared for an opaque answer there too.
• Don’t be guided simply by what the professionals are doing – they are just as frustrated with the situation as you are.