Three years after Europe’s asset management industry narrowly escaped new rules that would have restricted the use of performance fees, senior policymakers are again raising questions about the suitability of the charges.
Fund managers levy performance fees on investors when they beat market benchmarks. The fees are usually in the high double digits and are added to fixed management charges as a percentage of total assets.
The aim of these charges is to motivate fund managers to generate higher returns for investors. But there are question marks around whether performance fees truly motivate fund managers to outperform.
According to data from Morningstar, the data provider, analysed by FTfm, the largest European mutual funds that apply performance fees have underperformed funds without such charges over the past one, three and five years.
Senior policymakers are also concerned that these fee structures allow portfolio managers to take a slice of returns in good times, without an equivalent penalty for underperformance in bad times.
“Fund managers are in a win-win-win scenario a lot of the time,” says Sharon Bowles, former chairwoman of the European Parliament’s economic and monetary affairs committee, an influential panel of lawmakers in the EU, and a member of the House of Lords in the UK.
“We don’t mind performance fees, provided that if it turns out that you were pretty rubbish, there is a way of getting that [money] back.”
Performance fees have become more prevalent among mutual fund companies trying to maintain revenues in the aftermath of the financial crisis, according to Fitz Partners, a consultancy that specialises in fund charges.
Its data show that more than a 10th of European mutual funds have performance fees — and more than three-quarters of these have charged the fee in their last accounting period.
Results from some of Europe’s largest asset managers show that these fees have boosted earnings significantly. AllianzGI, Schroders and the asset management divisions of Deutsche Bank and UBS reported higher revenues last year from performance fees. AllianzGI’s performance fee revenue almost doubled to €607m.
Critics also argue that performance fees encourage fund managers to make short-term, risky investments, which do not pay off for investors over full business cycles.
We don’t mind performance fees, provided that if it turns out that you were pretty rubbish, there is a way of getting that [money] back
“Performance should be measured over five or even 10 years,” says Ms Bowles. “If you are a pension fund you want to know your cumulative [returns] over longer periods.”
According to the Morningstar data, the 20 largest European funds with performance fees returned an average of 6.2 per cent cumulatively over the past five years, compared with a 7.7 per cent return from the 20 largest European funds without such fees.
Over the past year the largest 20 funds with such charges delivered negative returns on average, compared with a small return of 1.1 per cent for those without. By comparison, the S&P 500 index of US equities gained 3.2 per cent over the same period.
Europe’s largest fund that applies a performance fee, run by Carmignac Gestion, the French asset manager, has significantly underperformed rival products in the same asset class.
Carmignac’s €24bn Patrimoine A fund, which charges a 10 per cent performance fee, returned -3.6 per cent, 5.6 per cent and 4.7 per cent over one, three and five years respectively. This compares with a return of 6.6 per cent, 7.3 per cent and 7.4 per cent for the Stable Return fund run by Nordea, the Scandinavian asset manager, over the same time periods.
“The fund’s total expense ratio remains lower than its peers,” said Didier Saint-Georges, managing director at Carmignac.
“Normally you would expect investors not to buy funds that have such misleading structures,” says Sven Giegold, the German MEP who was behind the unsuccessful push in 2013 for changes to the way performance fees are applied.
“When the market goes up, the returns look like they have gone up, so no one thinks that over a longer period the performance fee has killed your earnings,” he says.
According to James Hughes, deputy head of Cicero, the lobbying group, new EU legislation aimed at improving transparency around performance fees could cause investors to move away from such products as they become more aware of the impact of the charges.
The new rules, which fall under the second iteration of the Markets in Financial Instruments Directive that will come into force in 2018, will force fund managers to disclose the total fees they have charged and the cumulative effect of these fees on returns.
“The extra disclosure requirements in Mifid were very controversial,” he says.
But Mr Giegold believes the transparency changes are not enough without tighter regulation over the methodology behind performance measurements. “If [fund outperformance is measured] over very short periods of time, that is what creates the problem,” he says.
He says that plans to curb lucrative performance fees, which were voted down by the European Parliament in 2013, might be revived. They were shelved by Jonathan Hill, the financial services commissioner who departed his role following the UK’s vote to leave the EU.
Mr Hughes, however, believes that regulations coming into effect for retail funds, known as Priips, as well as Mifid II, will block any attempts to take rules on performance fees further. “There is not that much appetite to look at these rules again while Mifid and Priips are coming into force,” he says.
Nonetheless, some fund managers are taking the initiative to structure performance fees in a way that will avoid possible regulatory changes in the future.
Equitile, a boutique fund house, cancels management fees when performance fees are levied so that fund managers are forced to weigh up whether a riskier trade is worth the lost flat-fee revenue on total assets under management.
Andrew McNally, Equitile’s chief executive, says fund managers should have to measure long-term performance and should not be allowed to regularly reset the so-called “watermarks” they must beat in order to charge performance fees.
“If the economy has crashed and everyone is having gruel then you shouldn’t get a performance fee. If everyone is having gruel, so should you.”
Orbis, the $25bn fund house, follows a model used in Norway to counteract the “heads I win, tails you lose” system that fund companies are often accused of benefiting from. Its portfolio managers charge a high additional fee from investors when they outperform, but are also penalised when they underperform.
Dan Brocklebank, fund manager at Orbis, says that performance fees structured correctly are less risky than management fees because investors do not have to pay when there are poor returns. “Performance fees won’t improve performance per se,” he says. “They will help ensure that interests are aligned between clients and the manager, but they have to be structured well.”