The only kind of performance fee I wouldn't mind
Performance fees are a scam – just another way to transfer money from investors to fund managers. They shouldn't exist. But if they must, here is what they should look like.
I wrote earlier about the elements that make a fund manager successful. It is, I think, a mixture of luck and skill, with the former being the key bit. You can be the most clever manager in the world, but if you don't have the market's momentum moving behind your strategy you don't have a hope of making money. I had this in mind when I went on Moneybox on Saturday morning to talk about absolute return funds.
Paul Lewis pointed out that of the 65 funds billed as 'absolute return' in the UK, a mere 25 made positive returns last year. Worse, only eight managed to make enough to beat inflation. Absolute return funds are generally nothing of the sort. If one were to rename them in an accurate sort of way, one might go for something more like 'high-fee indifferent return' funds (snappier suggestions below please).
Much the same goes for the hedge fund industry. Jonathan Davis covers the inadequacies of the sector nicely, but the key point is that even if you make various favourable assumptions, between 1998 and 2010, "hedge fund managers earned an estimated $379bn in fees, out of total investment gains (before fees) of $449bn. In other words, they took 84% of the investment profits their funds made, leaving just 16% for the investors."
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Add in survivor bias, fund of fund fees and so on and it is "probable" that hedge fund managers have kept all the money they have made out of other people's money and "investors have in aggregate received nothing".
This dismal statistic brings us to the main culprit here the performance fee.This isthe thing that has worked to transfer the vast majority of those returns from the investor's pocket to the manager's pocket over the last decade.
I've written about performance fees many times before, but let me list again the many reasons for loathing them.
First is the fact that all funds charge management fees. And it seems to me that in paying this, investors are paying a manager to manage their money to the best of his ability. If he does this, why should they then pay him more? In many ways, outperformance should be its own reward. If a fund does well, more money will flow to it and the manager will then get more money in management fees: success is rewarded automatically.
So that's the basic problem. All the rest are with construction. If a performance fee is to be paid how should it be calculated? Has a fund outperformed if it does better than other funds? If it does better than an index? If it returns you more than cash in the bank? If it makes you a return over and above inflation?
Most funds go for one of the first two, with a benchmark fund being favoured. I don't really approve of this, because it seems to me that fund managers should do better than the index anyway. Not to do so is a massive failure. To do so is simply to begin to fulfil your mandate, not in any way to beat it. Another reason is that most of the indices they use don't include dividends. The much-used MSCI indices, by their own description "measure the price performance of markets without including dividends."
But dividends matter. Obviously, an index that includes them always does better than one that does not, so to use the latter as a benchmark is deeply suspect: it suggests outperformance when there is none.
Next up, 'high-water marks'. Imagine a fund that rises 20% in a year (say from a net asset value of 100 to one of 120), triggering a performance fee. It then falls 30% the next year (to 84) and rises 20% in year three (to 100.8). By the end of year three, the net return to investors after fees will be negative, yet the managers will have taken two performance fees!
Some funds operate a high-water mark so in this case, no further performance fee would be payable until the fund hits 120 again. But I am sorry to say that most still don't.
And even when they do operate a high-water mark, the retail investor could still feel pretty hard done by. He pays out a whopping performance fee in year one; he then loses all the performance (plus some more) in year two, but the fund manager doesn't have to give anything back. Win-win for the fund manager; win-lose for the investor high-water mark or not.
I can't think of a performance fee that I would love, but one I wouldn't mind would look like this:
It would only pay out if the fund beat: 1) the return on cash; 2) inflation plus 2%; and 3) the relevant index including dividends by 3%.
It would be capped at a relatively low level.
It would only be charged on funds with a management fee below 0.3% (and preferably zero).
It would have an inflation-linked high-water mark so that no fee could be paid out until the previous asset-value peak adjusted for inflation had been reached.
And finally, it would have rebate system. All money taken for performance fees would be held in an escrow account for five years and returned to the main fund in line with underperformance so when investors lose, managers lose too.
Fund managers getting fat on performance fees will say this won't work. I say it only won't work because they can't produce the regular good absolute returns they'd need to get a payout under my terms. And if they can't, why should we pay them as if they can?
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).
After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times
Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.
Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.
-
Shein’s London IPO could go ahead, despite forced labour concerns
The chief executive of the Financial Conduct Authority suggests that alleged human rights breaches aren’t a reason to block Shein’s proposed London IPO
By Dan McEvoy Published
-
Elon Musk's $56bn Tesla pay deal rebuffed again by US judge
It is the second time Musk's pay deal has been rejected, with judge Kathaleen McCormick upholding her previous January decision
By Chris Newlands Published
-
House prices to crash? Your house may still be making you money, but not for much longer
Opinion If you’re relying on your property to fund your pension, you may have to think again. But, says Merryn Somerset Webb, if house prices start to fall there may be a silver lining.
By Merryn Somerset Webb Published
-
Prepare your portfolio for recession
Opinion A recession is looking increasingly likely. Add in a bear market and soaring inflation, and things are going to get very complicated for investors, says Merryn Somerset Webb.
By Merryn Somerset Webb Published
-
Investing for income? Here are six investment trusts to buy now
Opinion For many savers and investors, income is getting hard to find. But it's not impossible to find, says Merryn Somerset Webb. Here, she picks six investment trusts that are currently yielding more than 4%.
By Merryn Somerset Webb Published
-
Stories are great – but investors should stick to reality
Opinion Everybody loves a story – and investors are no exception. But it’s easy to get carried away, says Merryn Somerset Webb, and forget the underlying truth of the market.
By Merryn Somerset Webb Published
-
Everything is collapsing at once – here’s what to do about it
Opinion Equity and bond markets are crashing, while inflation destroys the value of cash. Merryn Somerset Webb looks at where investors can turn to protect their wealth.
By Merryn Somerset Webb Published
-
Value is starting to emerge in the markets
Opinion If you are looking for long-term value in the markets, some is beginning to emerge, says Merryn Somerset Webb. Indeed, you may soon be able to buy traditionally expensive growth stocks on the cheap, too.
By Merryn Somerset Webb Published
-
ESG investing could end up being a classic mistake
Opinion ESG investing has been embraced with enormous speed and zeal. But think long and hard before buying in, says Merryn Somerset Webb.
By Merryn Somerset Webb Published
-
UK house prices will fall – but not for a few years
Opinion UK house prices look out of reach for many. But the truth is that British property is surprisingly affordable, says Merryn Somerset Webb. Prices will fall at some point – but not yet.
By Merryn Somerset Webb Published