David Prosser takes a look at performance fees.
One consequence of the retail distribution review for the investment company sector has been that many boards have felt compelled to lower their charges. The traditional cost advantage that closed-end funds enjoyed over their open-ended rivals, which always had to build the cost of commission payments into their fees, has been eroded now that no-one is allowed to pay commissions. Many investment companies have therefore decided to cut fees in order to maintain their edge.
As part of that trend, we have seen growing numbers of investment companies move away from performance-related charges – a dozen funds abolished such fees during 2014 alone.
On the face of it, however, that doesn’t appear to make much sense. After all, the point of a performance-related fee is to align the interests of investors and managers – the latter earns more only when the former is also seeing higher returns. That’s surely a worthwhile aspiration.
Interestingly, this appears to be the position of Neil Woodford, the star fund manager who is in the process of launching the Woodford Patient Capital Trust, a new investment company that will invest in early-stage companies. The final details of the launch have yet to be publicised, but Woodford says he will charge a performance fee but no annual management charge. Depending on the precise terms of the fee structure, this could mean Woodford and his colleagues will earn nothing at all if the fund disappoints.
So why are so many other investment companies moving away from this type of charge? Well, one reason seems to be that this is what intermediaries are pushing for. Winterflood Investment Trusts has just held an annual conference for the sector where it estimates wealth managers accounted for around half the delegates – it took the opportunity to poll them on their views on industry issues.
“Reflecting the continuing focus on management fees, we asked delegates whether they would be prepared to pay a higher base fee if any performance fees were removed,” explains Simon Elliott, an analyst at Winterflood. “Last year the response was even but this year there is a definite preference for the removal of performance fees.”
Winterflood thinks that view is unfortunate. “A well-structured incentive fee can be justified both on commercial grounds and in reducing costs in periods when performance is below target,” says Elliott. The key for investment companies though is to understand why intermediaries feel this way.
In large part, the explanation appears to be that many intermediaries don’t feel performance fees really have aligned the interests of managers and investors. The fees are too generous, they sometimes argue, too opaque for shareholders to fairly judge, and depend on performance targets that are far too easy to achieve. Plus most managers with performance fees have been charging them on top of annual charges, rather than in their place – heads I win, tails you lose, in other words.
These perceptions pose challenges to both advisers and investment company boards. Advisers need to be careful not to throw out the baby with the bathwater – as Elliott argues, well-structured performance fees can be good news for investors. Equally, boards need to do a better job of setting appropriate performance fees and explaining to investors why they’re deemed desirable.
In the meantime, Woodford’s lead may encourage others to reconsider the case for performance fees. It seems unlikely that investors and their advisers will shun the fund because of its charging structures – and if they can be made to work in a high-profile new launch, why not elsewhere too?
What the analysts say this week
Anthony Stern, Oriel Securities
“Many investors are concerned that supernormal returns over the last five years have led the biotech sector into bubble territory. We present the biotech bull and bear case and compare the valuations of the key US large cap biotech companies to those of their pharma peers. We conclude that the sector is not yet expensive.
Charles Cade, Numis Securities
“The results of Electra’s strategic review have been long awaited and we understand that they have involved considerable shareholder consultation. There are no surprises in the proposals, but we believe that they are positive for shareholders. The savings from changing the management fee of £4m and repaying debt of £7m, are equivalent in aggregate to 30.9p per share or 1 per cent of net assets.”