5th November 2021
A few weeks ago we wrote about the nuances around the importance of skin in the game (see here), and the fact that a fund manager’s remuneration and career prospects will always be tied to how the funds that they manage perform relative to their objectives, so there is always inbuilt alignment between fund buyers and fund managers.
There is another aspect of skin in the game that we did not address during that piece – performance fees. Like other aspects of skin in the game and alignment of interests, our views on performance fees are nuanced.
I will begin by saying that in principle we are not against performance fees, and in many cases are happy to pay them. But, and it is a big but, they have to be appropriately structured in order to be justifiable. What does that mean in practice?
Firstly, a performance fee must be considered alongside the management fee. We do not like any fee structure (management fee or performance fee) that is overly generous towards the manager relative to the returns that can reasonably be expected for investors from simply owning an asset class passively. For instance, if a plain vanilla investment grade bond fund manager launched a fund today and asked investors for a 1% annual management charge, they would rightly be laughed out the room given that it would wipe out most of the pitifully low nominal returns on offer for investors in the asset class. If they had the cheek to ask for a performance fee on top of that, I dread to think what might happen to them!
We don’t like performance fees that reward managers for average or sub-par performance. This seems like an obvious statement, but you would be surprised at how many funds still have performance fees that reward managers for the beta of an asset class, not for their alpha generation.
For example, if an equity fund with a management charge of 0.75% also charges a performance fee of 10% on returns in excess of zero we would not be happy. Over the long run, equity markets have achieved c.7% annualised returns, so structuring a performance fee with a starting point of 0% return is far too generous and is not justifiable. Similarly, if a fund has a base case return expectation of 8%, the minimum hurdle for a performance fee should be 8% – not below, as some try to get away with!
Performance fees should be there to reward alpha generation – i.e. for returns that investors could not have achieved if they had taken a passive approach to investing in the asset class. Not all asset classes can or should be accessed passively – including private equity, private debt and music royalties. If we are investing in an asset class that requires a very high level of technical knowledge that very few people in the world have (such as investing in biotech or healthcare), we believe that performance fees can also be justified as a scarcity premium – albeit they still have to be appropriately structured.
We are also mindful that there are times when performance fees can result in muddied incentive structures. If a manager has had an exceptional start to a year and is a long way ahead of the benchmark, they may seek to lock in that alpha and the performance fee by selling the portfolio and investing in an index tracker for the remainder of the year. It is therefore important to check in regularly and ensure there is no mandate drift after a period of strong returns and that your active manager stays active.
At one extreme, some funds are structured with no ongoing management charge and just a performance fee. This is admirable as it means that the manager is only paid if they generate alpha. Ashoka India is an example of an investment trust that has fees structured in this way. The team are relentlessly focused on outperformance and wanted a fee structure that both demonstrated their confidence in their ability to outperform the Indian equity market over the long run, and rewarded them for doing so. As a result, they structured the trust with no management fee and a (capped) performance fee of 30% of the outperformance of the Indian equity index.
However, for this extreme structure to work in practice it requires the management team to have other fee earning mandates elsewhere otherwise there may be periods where they don’t generate fees to cover fixed costs like salaries, office space and external research access. This type of structure also means that you may have to pay a performance fee for negative returns – i.e. if the index is down 50% and the fund is down less, then a performance fee would be due.
We believe that performance fees are appropriate when a fund is capacity constrained. Managers that don’t capacity constrain their mandates find that if they perform well then they enjoy significant asset growth and thus benefit from the rising revenues that the management fee generates – so a performance fee on top can be greedy. If a performance fee is a good incentive for a manager to focus on performance over asset growth then we are in favour. Ultimately, funds that grow too large relative to the asset class in which they invest find it harder to outperform too – they cannot adjust the portfolio quickly and often end up looking like index trackers due to liquidity constraints.
There are other aspects of performance fees to consider, such as how they are paid, the time period that they are calculated over, and whether or not there is a high water mark (i.e. a performance fee can only accrue when a fund is above its previous all-time high). On the former we like to see at least a portion paid in shares with a lock-up (for an investment trust) or reinvested into a fund (for an open-ended fund).
Some trusts have attractive additional clauses – for instance Biopharma Credit has a clause that states that if the trust is trading on a discount, all of the performance fee will be paid in shares which, at the margin, helps to narrow the discount and benefits shareholders.
The longer the time period a performance fee is calculated over the better, as you want to reward managers with performance fees if they can consistently deliver alpha – not if they have one amazing year where they take home a huge performance fee, followed by years of underperformance when a performance fee is not justified and should reduce the fee owed from the one good year. Finally, any previous underperformance should need to be caught up before a performance fee is due. For example, in year one a manager underperforms by 10%, in year two they outperform by 10%. No performance fee should be paid over the two years in that example, rather than no fee in year one and a chunky fee in year two.
Ultimately, given the vast array of nuances involved (which requires a dissertation as opposed to a short blog to try and cover in full!) we always consider performance fees on a case by case basis and are focused on ensuring they reward consistent alpha generation and are not paid for just taking market beta.
Dan Cartridge – Assistant Fund Manager
This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. HA4634.