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How to Minimise Fund Fees

Active managers in global markets, particularly in the US, have come under increasing pressure to prove that they can justify the higher fees that they charge

Morningstar 30 August, 2017 | 1:06PM

Fees have become a major talking point within the investment community; fuelled by regulation,  increased transparency and weak active fund performance. Active managers in global markets, particularly in the US, have come under increasing pressure to prove that they can justify the higher fees that they charge relative to most cheaper passive options.

This has highlighted the ever-present importance of considering fee structures in the fund selection process and minimising the underlying cost of investment.

Academics promoting passive investing have argued that active managers do a poor job of beating their respective benchmarks. Fees are the most cited reason for this underperformance, with a higher fee structure prompting investors to reconsider the value they are getting. This is usually depicted via the ‘OCF’, ‘TER’ or ‘AMC’ – all various attempts to transparently summarise the total underlying fees, yet not enough attention is directed to the underlying fee structure that derives these figures.

The Importance of Performance Fees

Performance fees are a common feature among active fund managers, particularly for many equity unit trusts. Funds with performance fees will often charge based on the outperformance of a specific benchmark over a period of time, and the motivation for this structure is that the manager is incentivised to outperform the relevant benchmark.

On face-value this appears reasonable and is supposed to create an alignment of interests between the manager and the end investor; the manager receives an additional reward when he or she produces excess returns for the end investor.

However, the reality can often be quite different. What is often not highlighted is what happens to the ongoing fund charge when the manager underperforms the benchmark or produces a negative return. Surely if they are able to charge additional fees when they outperform, investors should be reimbursed for underperformance?

It is within this asymmetry, in our opinion, where the problem often lies. The majority of managers that opt for a performance fee structure will charge a base fee which is independent of performance, along with an additional performance fee component if the manager beats the relevant benchmark. This is similar to the “two-and-twenty” structure that became common in the hedge fund industry – a base fee of 2% and a participation rate of 20% of any outperformance of the relevant hurdle rate.

Therefore, if they underperform they will be able to charge the minimum fee and if they outperform they will charge an additional performance fee component, which creates an asymmetric return profile that benefits the manager.

What should be apparent from the above is that any fund which elects to charge performance fees can have highly variable costs associated with fund management. This would be especially true for funds that have a more volatile return profile.

Paying for Services Not Rendered

The basic definition of value is to get more than you pay for. This applies equally in the grocery store as it does in the investment selection process. Yet, one of the chronic problems in asset management is that some investors pay money for zero value at all.

Specifically, the performance fee calculations do not always cater for each individual investor. A classic example is when a person enters a fund following a period of stellar growth. Little did they know there is a pending performance fee about to be charged for outperformance they never participated in.

This leaves an investor in a detrimental position where a daily management accrual fee is treated the same way for someone who has been invested in the fund for 10-years and a person who enters the fund for the first time and has only been invested for a few days. The sad reality is that these performance fees can be potentially uncapped too.

What Can an Investor do?

All else being equal, we distinctly favour flat fee structures over funds that charge performance fees due to the inherent uncertainty the performance fee component creates for end investors. Performance fee structures can sometimes be very complicated and difficult to understand, thus adding further uncertainty to the portfolio outcome.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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