Paid extra just for doing your job?

Should financial advisers feel comfortable recommending funds that carry performance-related fees? This method of charging has been going out of fashion in recent years amid something of a backlash, so a recent shake-up of the fee structure at Scottish Oriental Smaller Companies Investment Trust catches the eye. The board of the fund has agreed that its manager should be able to get more of a reward, assuming it hits certain performance targets, though it has also introduced some additional caveats.

The argument for performance-related fees – advanced by Scottish Oriental, like other funds that carry them – is that they align the interests of the fund manager and investors. If the manager outperforms, everyone shares in the spoils, so everyone should be happy.

However, critics of these structures argue that managers are effectively being paid extra just to do their jobs. There’s also the worry that performance-related fees incentivise excessive risk-taking – that managers chasing an outsized payday will be too aggressive with asset allocation and stock selection.

The other common complaint about performance-related fees is that while they may work well in principle, they can be poorly structured in practice. They may be set with reference to an inappropriate benchmark or make it too easy for the fund manager to beat its targets. Sometimes, the fees paid have been very high. And investors have baulked at paying out one year with no right to a refund during any subsequent periods of underperformance, though this isn’t the case at Scottish Oriental.

Certainly, where an investment company does decide a performance fee is appropriate, investors are entitled to expect it meets certain standards. For example, it seems reasonable that any base management fee is lower than normal, or there’s little point in having the extra fee. The benchmark should be relevant, and the hurdle rate required to trigger the fee should be challenging.

In addition, look for a “high-water mark” so that if a fund falls in value, the manager can’t claim a performance fee until it has recovered its previous high. A cap on the total value of the fee is also desirable, while making some of the award in shares to the individual manager will further align their interests with shareholders.

In the end, of course, the biggest question is whether performance-related fees deliver what they’re designed to – additional performance for investment trust shareholders.

The evidence here is mixed, but hardly compelling. A recent study, published last year by RBC Brewin Dolphin, found that average yearly returns from global, Japan, North America, UK all companies and UK equity income funds with performance fees failed to keep pace with their peers. On the other hand, funds with performance-related charges investing in Europe and Asia had done better than peers with more conventional charging structures.

Most other research in recent years has reached the same conclusions. A paper published a little while back by Architas, for example, found that eight out of ten UK funds that charged retail investors a performance fee had failed to beat the global stock market over the previous three years. Analysis of European funds conducted by the Financial Times produced similar findings.

This is not to suggest these structures are guaranteed to produce poor results, but there has certainly been no slam dunk for performance-related fees in research published to date.

In the end, advisers and their clients will need to judge each case on its merits. In general, the trend in the investment trust industry in recent years has been towards lower charges. And where funds do levy performance-related fees, they have often worked hard to create structures that try to be fair to both the manager and to investors – Scottish Oriental’s shake-up is a case in point.

In the long run, however, the proof will be in the pudding. Advisers will want to see returns that justify the extra fees. And even where they get them, there’s no way to test the counter-factual – would this performance have been achieved with a more conventional fee structure?