Are performance fees on absolute return funds justified?
By Valentina Romeo
Fund selectors have questioned whether performance fees on absolute return funds should be capped as new research reveals managers made hundreds of millions off investors in variable charges last year.
An analysis of 15 of the largest funds in the Investment Association Targeted Absolute Return sector that have performance fees shows some charged more than £100m last year, on top of ongoing charges. In one instance, the £543m Polar Capital UK Absolute Equity fund charged more than 8 per cent in performance fees.
Experts suggest there should be a cap on what fund managers can earn as a percentage of the fund, especially when performance fees are applied to very large funds.
The £10.9bn ($15bn) Old Mutual Global Equity Absolute Return fund charges a 1.65 per cent performance fee, meaning it made around £153m net of the ongoing charge fee in 2017.
Other funds, such as Global Absolute Return Strategies at Standard Life Aberdeen, did not hit performance targets in 2017, so did not charge performance fees for the period.
The analysis carried out by AJ Bell for Money Marketing also shows performance periods often vary between fund manager accounts and Key Information Documents.
Data shows that a performance fee of 20 per cent over a hurdle rate is common for funds in the sector, but the fees vary depending on the level of the fund’s outperformance.
The average performance fee of OMGI Global Equity Absolute Return’s clean retail share class over five years is 1.55 per cent as at the end of 2017, according to the firm.
An OMGI spokeswoman says: “The performance fee is subject to a high watermark, meaning investors only pay a fee for outperformance achieved above the highest published price for the share class as at all prior payment dates. Consequently, investors will not be charged a performance fee for gains made as the fund recuperates losses.”
As of 30 April, the fund delivered returns of 33.1 per cent over five years, compared with the IA Targeted Absolute Return sector average of 13.7 per cent, according to FE.
The Polar Capital UK Absolute Return fund delivered a return of 47.5 per cent net of all fees in 2017. In comparison, the FTSE All-Share Index’s total return was up 13.1 per cent for the same period.
A Polar Capital spokeswoman says: “While a performance fee was generated and paid over that 12-month period, we believe the net money return to our investors should be the ultimate measure of our value add. We remain resolutely focused on delivering differentiated investment products and superior risk-adjusted returns to investors and believe we can and do deliver value for money.”
"Often the benchmark is Libor related with these funds and the rewards seem stacked in the favour of the fund manager"
Seven Investment Management senior portfolio manager Peter Sleep says performance fees can “make sense” for investors as an alternative to increasing management fees.
He says: “A lot of funds will have performance fee share classes, with a low management fee, or a higher management fee and no performance fee, giving a choice. So long as they are adequately disclosed I cannot see how anyone can object.”
Sleep says if a fund charges performance fee it should have a high watermark, so if it drops investors do not pay for the rebound. Fund managers also need to make sure funds target an “appropriate” benchmark.
Sleep says OMGI only charges a performance fee if it beats the equity market since the fund solely invests in equities. This is different from what some hedge funds do as they are benchmarked to cash, so they take a performance fee for beating cash, which is zero, when they invest in something else.
Shore Financial Planning director Ben Yearsley agrees on having a clear benchmark for performance fees but is sceptical when these are applied to absolute return funds specifically.
He says: “Many performance fees do have a form of cap in that, for example, the total OCF including the fee doesn’t go above a certain percentage. I can’t see a scenario where a fund group voluntarily caps a performance fee at a maximum monetary amount. If investors don’t like the fee structure, simply don’t invest in that fund.
“But in absolute return funds often the benchmark is Libor related and the rewards seem stacked in the favour of the fund manager.”
However, in the case of OMGI, Sleep notes that since Global Equity Absolute Return’s performance fees are calculated by the administrator, Citibank, checked by the depository, Citigroup, and the auditor, KPMG, there should be no question about the fees taken by the asset manager .
But Architas investment director Adrian Lowcock argues performance fees on absolute return funds remain “excessive” especially as they are charged on top of the total expense ratio. He argues that the TER is in itself a performance fee as the amount earned rises as the fund grows in size.
He says: “Performance fees seem excessive given the sector doesn’t deliver or often even target high returns, especially when compared with equity funds for example, so paying extra fees for what they aim to deliver seems contrary to delivering returns for investors.
“While capping is nice and high watermarks are better than none, they are not a perfect solution as investors could still pay performance fees but lose out due to timing and selling.”
Lowcock notes the model used by Orbis Investments, although complex, could be considered the best solution compared with other models as the firm charges performance fees but no annual management fees.
Sleep claims profits from absolute return funds are generally absorbed by the portfolio management team rather than the wider fund management company.
He says: “We have seen with many funds, such as Neil Woodford at Invesco, how easily the portfolio manager can walk and how the previously successful fund can shrink in size and fees quite quickly. Even if the manager does not walk any period of good performance may be followed by a period of lean performance.
“OMGI may appear to be gathering a lot of fees, but a lot may be going to staff. Today’s apparent success may be transitory unless they are careful.”