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With performance fees the “Devil is in the detail”

Although the financial services sector is backed by a sound regulatory and legal framework, not enough is being done to ensure full transparency in terms of investment management fees. It is almost impossible for decision makers and members to make informed investment decisions as it is very difficult to compare the different types of investment fees and the levels of fees that are being charged. In addition, although some service providers claim that their fees are fully disclosed, they only disclose the level of the fees and not the details of the calculation methodology. With performance fees, the “devil is in the detail” and it is vitally important that members have access to this kind of information to consider appropriate investment vehicles.

Most investment managers charge investors an investment management fee. This fee is normally easy to compare and well disclosed in marketing material and fund fact sheets. It is generally a flat fee, or calculated on a sliding scale, accrued daily and charged monthly in arrears.

Example:

Investment management fee = 1% of assets under investment. 1% x R1 000 000 (assets under investment) = R 10 000 investment management fee per annum.

On the other hand, even though investment management fees are common in South Africa, performance fees are not always readily available, nor well disclosed in the industry, which could be due to complicated calculation methodologies.

When negotiating investment management fees with investment managers, there are basically two options to consider:

a high investment management fee, with low or no performance fee, or

a low investment management fee with a possible higher performance fee.

When comparing investment portfolios and investment fees it is important to understand the different types of fees, how they are calculated and what the maximum possible fees are that could be charged. This is especially important where performance fees are levied.

Pointers to consider when comparing investment performance fees:

Asset classes: it is generally accepted in the industry that performance fees are more appropriate for the so called growth asset classes such as equities. Depending on the nature of the investment mandate, it does make sense to charge performance fees on the more aggressive asset classes where you do want to reward the investment manager for superior performance relative to a challenging benchmark. With the more conservative asset classes, where you do not always want investment managers to take on too much additional risk in an attempt to generate outperformance, it is important to ask the investment manager whether they charge performance fees on the more conservative asset classes such as money markets, bonds and inflation linked bonds.

Benchmark: performance fees should only be payable where managers have outperformed appropriate and challenging benchmarks. It is important to only reward investment managers by paying them performance fees where they have demonstrated skills and the ability to consistently add value relative to a relevant benchmark. For example, an aggressive balanced portfolio should not be benchmarked against a cash plus or an inflation plus benchmark. It makes more sense to use a composite benchmark that reflects the strategic asset allocation of the portfolio and the various returns of the underlying indices, which the asset classes are being benchmarked against.

Hurdle rate: managers have to outperform the benchmark and an appropriate hurdle rate before performance fees are paid. This means that the investment manager will have to outperform the challenging benchmark by an additional margin prior to them earning any performance fees. If, for example, the hurdle rate is 1% for the local equity managers and the benchmark return is 10% for the period under review, the manager will only earn a performance fee for returns generated in excess of 11%.

Reasonable participation rate: Investment managers should only share in part of the out performance and this is referred to as the participation rate. For example, if the participation rate is 20%, the investment manager will only get 20% of the outperformance of the benchmark plus the hurdle rate. In this example, the members will receive 80% of the outperformance. If we use the example above where the benchmark return is 10% and the hurdle rate is 1%, the investment manager will earn a performance fee of 0.8% for actual investment performance of 15%. Note that the member will receive most of the outperformance, which is 3.2% of the 4% (i.e. 15% less (10% +1%)) outperformance.

Time period: performance fees should be calculated over longer time periods and investment managers should not be rewarded for short-term out performance. The principle is to reward consist outperformance over a longer term.

Capped at appropriate level: performance fees should be capped at appropriate levels. This is to ensure that investment managers do not take undue risk in portfolios in an attempt to generate outperformance. For example, if you cap the performance fee at 1%, an investment manager will only participate in the first 5% of outperformance and all the outperformance above this level will be allocated fully to the members. There is therefore no incentive for the manager to try and outperform by more than 5%.

Example:

If the benchmark return and hurdle rate is 11% and the actual investment return is 17%, the out performance of 6% is split between the manager (20% that equates to 1.2%) and the client (80% that equates to 4.8%).Given that the performance fee is capped at 1%, the investment manager will only receive 1% and the member will get the difference, which is 5% of the outperformance.

It is very important to consider all the different types of fees and the level of these fees before advising your client on the most appropriate investment portfolio or range of portfolios. In the spirit of treating clients fairly, investment managers should support government and the move to enhanced transparency and the disclosure of fees. Performance fees, that are often not included in portfolio reviews, can make up a substantial portion of the total investment management fee that may be payable and should therefore be considered to ensure that investment management fees are not unnecessarily high. The ideal situation is to have a low investment management fee plus a performance fee that is conservatively constructed, fully disclosed and that only rewards the manager for outperformance.

If you have more questions on how to compare investment management and performance fees contact your FundsAtWork specialist or business development manager or send your question to: FAWInvestmentQueries@momentum.co.za

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