Any fee mechanism will have pros and cons and different people will prefer different features.
Many investors are finally realising that the idea of paying fees to a fund manager even if they underperform the market doesn’t make much sense. While the pace of change in the fund management industry can be painfully slow, the good news is that more fee structures are now being offered that are designed to create a much clearer link between fees paid and results delivered for clients. This is an important part of the general trend towards putting greater emphasis on value for money.
Unfortunately there is no such thing as a perfect fee structure. Any fee mechanism will have pros and cons and different people will prefer different features. But don’t be put off if the details seem daunting. We believe there is a core set of simple questions that DIY investors can ask to make better decisions when evaluating fee structures.
Here’s a checklist to get you started:
Are you comparing apples with apples?
This may sound like an obvious question but the most basic thing to check is that the benchmark being used by the fund manager is appropriate and realistic for their investment approach. For example, if the manager’s remit is to buy global equities, you don’t want their performance assessed relative to UK equities, bonds or even cash. Any calculation of performance for fee purposes should use the same benchmark as the fund’s stated overall objectives. The FCA’s recent work has found that some funds have used inappropriate benchmarks, so be very cautious if the choice of benchmark doesn’t make sense.
Is there a 'base' fee?
A base fee is a fixed percentage fee that is paid to the manager regardless of performance. Generally speaking, the lower the base fee, the better. For context, tracker funds typically charge a fixed base fee of approximately 0.1 per cent per annum for providing benchmark performance. In some performance fee structures, the base fee can be as low as 0 per cent, making them even cheaper than tracker funds for benchmark-like performance.
What percentage of any outperformance is the manager entitled to?
This can vary from 10 per cent to 50 per cent and it will be set in conjunction with the level of the base fee. For example, a 0 per cent base fee would have a higher share of performance while a higher base fee should come with a lower performance component. Remember, the goal is to avoid an outcome in which the manager benefits handsomely from both the base and performance fees.
Is there a refund or clawback mechanism?
If it’s not clear, ask the fund manager the following question: what happens if they outperform by 3 per cent one year, but then underperform by 3 per cent the next year? Does the manager get to keep the performance fees earned in year one or do they have to give some of it back? According to an academic paper by the CASS Business School published in October 2014, the best structures (from an investor’s perspective) offer a symmetrical refund mechanism. In other words, refunds are paid by the manager when the fund is underperforming in the same proportion as performance fees were charged when the fund outperforms. By the way, this is not just an academic idea: a symmetrical structure is available to retail investors in the UK from at least one provider. I know that because we offer it at Orbis.
That’s not to say that we have the only solution. Indeed we are excited to finally see fresh thinking on fees. The FCA has also noted and welcomed the recent rise in ‘innovative’ fee structures as part of the more general move to force the industry to address the issue of value for money. It’s a refreshing change and long overdue.
Of course, the cynics and vested interests don’t see it quite the same way, but I think they may underestimate just how frustrated many investors have become with this industry—and rightly so. As one well-known UK fund manager put it in July 2017, the industry can expect to continue earning 'superior economic returns' as long as the standard ad valorem fee model remains the norm.
That would be perfectly fine if those returns were earned by providing a service that represented great value for money—but sadly they are not. This has created a fantastic opportunity for fund managers to restore trust by offering fee structures with genuine accountability for performance.
Dan Brocklebank is head of UK at Orbis Investments.