Commentators are divided on the merits of the fee structure. Clearly, a performance fee without an AMC is better than paying both. However critics noted that returns include unrealised as well as realised gains.
Some advisers refuse point blank to look at products that offer performance fees; their clients will be missing out on one of the hottest recent fund launches. Is this blanket refusal to engage with performance fees defensible?
Investment trusts and performance fees
Woodford PCT is not the only new entrant to the market to include a performance element in its remuneration – River and Mercantile UK Micro Cap and Sanditon Investment Trust, both of which launched the second half of last year, also did so.
Around half of investment trusts still pay performance fees and, although some funds are moving away from performance fee structures, the proportion that is doing so is lower than expected. In 2014, 16 trusts with performance fees went through a fee restructuring. Out of these only six removed the performance element. The boards of the other 10 clearly felt that there continued to be a place for the performance fee.
Inappropriate for retail clients?
Sceptics argue that performance fees have no place in investment trusts. Performance fees, with their hurdles, high water marks, carry forwards and rolling performance periods, are difficult to explain to retail clients and, worse, their cost and impact on net returns cannot be calculated at the time of investment.
Compared with a UCITS or NURS with a single annual management charge (AMC) , they seem unnecessarily complex. Historically, performance fees also proved expensive, rewarding performance relative to benchmarks but paying out even when investor returns were poor.
Developments in performance fee structuring
But performance fees, structured appropriately, align the investment manager with investors and allow base fees to be kept to a reasonable level. Limiting fixed costs, such as the AMC, in favour of variable performance fees means investors only pay more if returns have been strong.
In the past, there were fee structures that were over-generous to fund managers. But managers are not the only ones to have benefitted in the past from generous fee structures.
These days, performance fees tend to be carefully structured to avoid investors paying for poor performance. Rare are the performance fees that do not include high watermarks as well as a carry forward of any underperformance.
We are also seeing innovation in the form of performance fees linked to the market capitalisation of the fund rather than its NAV – for example Woodford PCT, as already noted or the River & Mercantile structure, where payment of the fee is linked to the return of value to shareholders.
What is the right comparator?
It is important to consider what the investment trust is being compared with. In most cases, if the investment strategy were suitable for a UCITS it would be pursued through a UCITS fund. If the strategy isn’t suitable for a UCITS why compare the fee structure to what pertains in a UCITS fund?
Investment trusts uniquely offer the returns of a closed-ended, geared product with a decent level of liquidity. Instead of comparing them with UCITS, it might be better to reflect that long-term investment strategies and gearing might not otherwise be available to retail investors – who have no means of accessing private institutional funds.
Compared with the priority profit share and carried interest paid by investors in private funds, investment trust performance fees might be seen as good value. Investment advisers who automatically discount investment trusts with performance fees may therefore do their clients a disservice in closing off investment strategies to which their clients might not otherwise have access.
What does the future hold?
Looking to the future, investment trusts will be covered by the PRIIPs regulation and will not be able to be sold to retail customers unless a KID is available. ESMA’s technical standards will specify how ongoing charges are to be calculated and how variable fees, like performance fees, are to be disclosed.
The aim of the PRIIPs regulation is to promote transparency and facilitate product comparisons so, if it does its job, the complexity argument against performance fees should go away.
To summarise, performance fees are unfairly demonised. Appropriately structured, they create considerable alignment between manager and investor. Much has been done in recent years to make performance fee outcomes fairer for investors.
They are just one feature of investment trusts and, like all such features, each should be analysed and assessed on its own merits and in the context of the whole fund and its comparator products.
This article was first published by FE Trustnet: http://www.trustnet.com/News/595364/have-performance-fees-been-unfairly-demonised/