Who should pay for underperformance?

Investors are increasingly unhappy that they still have to pay charges for funds that are falling in value. But what’s the alternative, if there is one at all? (This article was written prior to the UK’s referendum on the EU)

Stock markets around the world suffered incredible volatility in the first half of 2016 for a whole range of reasons – not least the lead-up to the EU referendum, economic weakness in the Far East and an uncertain oil price. And things don’t look set to change any time soon.
 
In the middle of June, the FTSE 100 fell below the 6,000 mark once more, standing lower than it did at the start of 2013, and way below the highs of 2015. At the time of writing, prior to the EU referendum on Europe, there are fears that stock markets will ‘tank’ should voters opt for a Brexit.

With this in mind, troubled investors who have money in funds that have fallen in value, and may well fall further, might reasonably expect those funds to share some of the losses. Sadly, the vast majority of investors are going to be disappointed and will likely still pay for the ‘privilege’ of being in poorly performing funds.

Annual management charge

It’s long been a criticism of retail fund managers that they levy an annual management charge (AMC) even if their funds perform badly. This AMC is typically a fixed percentage (usually between 0.75 per cent and 1.0 per cent) of their assets under management (AUM). 

In some cases, funds even charge ‘outperformance’ fees on top of the AMC, the rationale being that so long as the fund manager’s hard work results in their outperforming their benchmark, they deserve such a payment. For hedge fund investors, this is a typical model – a two per cent AMC and a 20 per cent performance fee are quite normal.

However, this can result in investors paying an ‘outperformance’ fee despite the fund having lost them money. For example, investors in Fidelity’s China Special Situations Trust had to pay performance fees despite the share price having fallen, as its losses weren’t as bad as those of its benchmark, the MSCI China Index.

This is because Fidelity is entitled to 15 per cent of any change in the trust’s net asset value (NAV) that is more than two per cent above returns from its benchmark – capped at one per cent of NAV. Such a payment is expected on top of the base management fee of one per cent of NAV.

Such actions will revive the debate over fund performance fees. Indeed, canny investors are already wary of fund costs, as Sandy Forbes, a member of the UK Shareholders Association and a private investor, notes. "The majority of funds’ management charges are way too high,” he says. “So much so that they don’t reflect the skills of the manager’s investment selections but they do instead reflect ‘the going rate’."

Striking a balance

AMC fees have come under strong criticism from some academic quarters. In its report Heads you win, tails we lose, Cass Business School showed a fixed fee was generally the best structure for the fund manager and the worst for the investor.

Professor Andrew Clare at Cass explains: "What these fund managers want is an annuity, which doesn’t fall. Or at least doesn’t fall very much. If managers are as good as their word, they should be putting their own money where their mouth is. 

"They tell us they beat the benchmark every year, and all this sort of stuff, and yet they aren’t willing to take the risk that they might actually lose money alongside their investors."

Clare is strongly in favour of symmetric fees, where the fund manager receives a share of the profits when the fund outperforms, but also bears some pain when it does badly.

At the time of writing, only three funds in the UK appeared to offer this – Neil Woodford’s Patient Capital Trust and two from Orbis Access. The Woodford fund doesn’t have an annual management fee, but has ongoing annual expenses capped at 0.2 per cent of total assets – it receives a performance fee of 15 per cent only if it delivers a cumulative annual return on NAV in excess of 10 per cent. In addition, the trust must beat the previous peak in NAV before the performance fee kicks in.

It’s a demanding target. Still, as it’s an investment trust whose share price can differ from the value of the underlying assets per share, it’s theoretically possible that Woodford can earn a performance fee for a period in which the share price fell.

Orbis’s two funds, Global Equity and Global Balanced, only charge performance-based fees if the fund outperforms its benchmark. If it does, it goes halves, taking 50 per cent of that outperformance. If it fails to beat the benchmark it refunds half the difference to its investors.

Stick or twist

The Investment Association is the trade body representing UK investment managers who cumulatively manage more than £5.5trn of client money. Most of their funds charge a fixed fee as a proportion of AUM. A spokesperson argues that a move to symmetric fees might make it hard for funds to withstand years of underperformance. 

He says: "Investment managers don’t frequently offer structures that include no AUM-based annual charge element, but if a firm was able to make such a structure work for their clients, then that would be commendable." 

He also states that investors are free to move their money out of underperforming funds, so rewards (based on AUM) do eventually relate to performance.

It’s an argument that doesn’t carry much weight with Professor Clare. He points out that, in practice, retail investors are slow to pull out from underperforming funds. He wants to see more funds offering symmetric fees. "It doesn’t have to be excruciatingly painful for the fund manager – they could step it. Maybe the pain isn’t completely shared, as with Orbis, but partially shared; so instead of taking 50 per cent of the downside, they take only 30 per cent."

Dr Peter Westaway, Head of Vanguard Asset Management’s Investment Strategy Group in Europe, also believes low-cost funds outperform. "Our analysis reaffirms previous academic studies by Vanguard and others that low-cost funds have tended to perform better than high-cost funds over time," he says.

"Consequently, it’s important that investors pay attention to costs because in the world of investing, you don’t always get what you pay for."

Kay Ingram, a Divisional Director at independent financial adviser LEBC, isn’t convinced symmetric fees would help investors. "The funds still need managing, whether they make money or not, and if fund management houses only benefit from gains it could lead to bigger risks being taken to benefit them on the upside," she says.

"The charges levied for UK retail funds accessed via the intermediary market have fallen substantially since the retail distribution review in 2013. Competition and an active intermediary market should help keep charges down – it’s something we consider when selecting funds – but it’s important not to confuse cost and value." 

Clearly, funds charging only for performance and offering to share investor pain face obstacles. However, if they can deliver good returns they’re sure to increase in popularity and prosper alongside their investors.