More secrets… not all dirty

Stuart Pearce

I would like to expand on the “Dirty Secrets fund managers don't want you to know” wire by Lachlan Hughes from of a couple of weeks back.

Is your manager “double dipping”?

Some fund managers and brokers have “soft dollar" arrangements, where a proportion of commissions (paid from fund assets) are directed toward paying manager expenses. This can only mean higher brokerage rates than otherwise, but it is considered acceptable industry practice provided it is “disclosed”. Your $500m fund may well be paying an extra $500,000 each year in commissions so that its brokers contribute that amount toward your manager’s operating costs.

Is your benchmark ideal?

This was perceptibly raised in comments after the original piece. Most managers choose a benchmark that reflects the fund’s return objectives. To the extent that this also reflects a fund’s risk profile it makes perfect sense. But what about your long/short equity fund that applies the RBA cash rate, or 0% as its benchmark? Does shorting an equal amount of long equity exposure eliminate equity risk? I suggest not. Does your manager get a "free ride" on equity risk?

Are your manager’s balls on the line?

Performance fees provide managers with asymmetric payoffs. True alignment requires capital at risk. Many individuals running funds are paid millions. How much does your manager invest in your fund?

“When taking a flight, you want the pilot on the plane” Leon Levy

Does your fund’s performance fee include a high water mark (HWM), does it increase, can it be reset?

A HWM requires prior periods of underperformance to be recouped prior to future performance fees being paid. Despite being investor friendly, you may like to consider whether your fund’s HWM increases (a Hurdle) and whether your manager has ever reset any of their HWM’s. When you check the details – you may well find yourself invested with a manager that every month, quarter or year is playing a new game of heads I win, tails I don't lose.

How frequently does your fund pay its performance fee? Are you treated fairly?

I agree with the premise of the original piece (that the less frequently performance fees are paid the less likely investors will pay for performance that is subsequently reversed). However to implement this in practice is not simple because the “correct” performance fee will always be different for investors that subscribe at different prices. Accruing it daily does not solve this problem.

Consider the following example of a fund that applies a performance fee of 20% above 0% - and because the manager strives to be investor friendly - it only pays it annually:

  • it has a unit price of $1.00 at July 1;
  • it experiences a return of 100% over the first six months, so at 31 December its gross value is $2.00 and having accrued a $0.20 performance fee liability, its net value is $1.80;
  • it then suffers an investment loss of 25% in the second half - so its gross value falls from $2.00 to $1.50 as at 30 June. At that time, a $0.10 performance fee is paid and the remaining $0.10 of the prior liability is reversed, so its net value is $1.40.

So, the investor that held the units for the full year experiences a gross return of 50% ($1.50 compared to $1.00) and a net return of 40% ($1.40 compared to $1.00) after paying their fair share for performance (20% of the $0.50 increase in gross value). All good.

But let’s say you invested on 1 January at the prevailing net value of $1.80. How would you feel knowing that despite your investment falling in value by 22% over the subsequent six months ($1.40 compared to $1.80) you paid your manager a performance fee? And what’s more, imagine it accounted for a whopping quarter of the decline in your investment? It’s not one-sided. Assume an opposite return profile for those half year periods. You would have been particularly lucky. Not only would you have bought at the low point of $0.75, but the first $0.25 of your gain would not have incurred a performance fee - you would have enjoyed a “free ride”.

What’s the solution? Perhaps new investors should only subscribe on the day after the performance fee is crystallised (resetting the HWM), or when the unit price is at or below its level when the last performance fee was paid (so you get the “free ride”). Alternatively, if the fund offers it and you are eligible, consider subscribing to a monthly priced series of units issued with their own HWM.

Seen from this perspective more frequent payments are often justifiable. And of course the only way to ensure investors never pay for performance that ultimately reverses is to only pay performance fees on redemption. But it is not reasonable to expect a manager to wait a long and uncertain period before being paid.

Have you considered buy/sell spreads?

Admittedly these observations have negligible impact for long term investors - but buy/sell spreads are not included in performance tables or the “Manager Fees” and fee examples in a PDS - presumably because they are paid to the fund and not to the manager. They are however included in performance fee calculations - so new investors not only incur the spread - they pay their new manager a performance fee related to it!

Conclusion

These are observations I highlight to help investors understand more “industry nuances”. Some are unavoidable flaws, so it is unfair to call them “dirty secrets”. And also let’s remember, it's what you - the end investor - take home after fees that is ultimately most important.


Comments

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Medium steve edit 2

Steve Johnson

Mostly valid points but your point on the accrued performance fees is incorrect. The gross value of the portfolio has fallen 25% in your example ($2.00 down to $1.50), whereas the investor has only suffered a 22% loss (1.80 down to 1.40) thanks to unwind of accrued performance fees. Had the fee been paid out prior to investment the unit price would have fallen to 1.35 instead of 1.40. The less frequent the payment of performance fees the better (for investors).

Medium team stuart

Stuart Pearce

Steve, thanks for your comments. I respectfully disagree that any points are incorrect. Applying a $1.35 end price and backing out the performance fee would equate to a $1.6875 gross price, or a 68.75% gross return over the year. But the assumption is a 50% gross return over the year. I agree that if the fee had been paid at 31 December the gross and net unit prices would both be $1.80, and the end price would have been $1.35 and the investor's loss would also be 25%. But because the premise of the example is annual performance fee payments, the correct base for the -25% gross return is $2.00, not $1.80. It illustrates that the annual payment frequency reduces the 25% loss at the gross level to 22% at the net level by the unwinding of the performance fee. A good thing. But it also shows that the investor pays a $0.10 performance fee for a $0.40 loss. As you correctly state, a half yearly payment period would avoid this. The point is that less frequent payment of performance fees is always optimal for fund investors when assessed as a whole, but not necessarily for each individual investor in the fund.

Medium steve edit 2

Steve Johnson

I think most investors would prefer a 40c loss to a 45c loss. They new investors don't pay the performance fee, it was already accrued in the price they paid. You are right that 10c cash gets paid out, but on the day they invested they already got a 20c discount because of the accrued performance fee.

Avatar fallback

Adrian Querzoli

Hi Stuart, I raised the comment last time the PF needs a daily reconciliation to treat new investors fairly. I don't understand why the HWM would reset to 1.50? I though High Watermark is literally that so it shouldnt it be fixed at the 1.80 if that was the peak in NAV.

Medium team stuart

Stuart Pearce

Thank you Steve for correcting and clarifying. The point I wish to make is that without individual HWMs, the more frequent the payment the more likely the allocation of the fee among individual investors is fair. For a better illustration let's continue the example and the assumption of annual payments. The HWM would reset at $1.50. And let's say the Fund's gross price at the end of the following year is $1.70 so the accrued performance fee of 4c is paid and the resulting net value is $1.66. Now the investor we referred to previously that paid $1.80 originally would incur the fee despite incurring an investment loss. However had the fee been paid semi-annually (at the $1.80 level), the resetting of the HWM at that level would mean no performance fee would be incurred and the end unit price would be $1.70. Correct?

Medium team stuart

Stuart Pearce

Hi Adrian, Thanks for your comment. My understanding is that the HWM typically only resets at the time the performance fee is paid. If it reset at the peak NAV during the applicable period, then that would solve the issue and I would be very happy to stand corrected. Perhaps others (Steve?) can chime in with their understanding. I'd suggest check the fine print in the PDS, but you'd probably have to go to the additional info booklet or even the Constitution...

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Adrian Querzoli

I suggest it might be clearer to talk about calculation (instead of accrual) vs payment. I understand the HWM is part of the calculation of the PF. Same as the benchmark, hurdle rate and calculation frequency. I agree daily calculation and annual payment would be an investor friendly practice. The calculation needs to be at least as frequent as the application/redemption frequency to ensure unit prices are fair. So if the fund only takes applications weekly, then weekly calculation is adequate.

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