Unit trust investors are increasingly being charged investment management fees on the basis of performance, instead of a fixed fee. Pioneered in the retail market by Allan Gray 10 years ago when it launched its unit trust business, the concept has gained popularity with both investors and asset managers in recent years.

Johan de Lange, Director of Allan Gray Investor Services, says performance fees encourage fund managers to act in the best interests of their clients by focusing on generating investment performance rather than chasing growth in fund size.

Performance fees focus managers' attention

“Because the fee a fund manager earns is dependent on returns relative to a goal or benchmark, performance fees have a way of focusing fund managers’ attention on producing the best possible return for clients,” says de Lange.

Performance fees can be calculated in different ways. Ideally, they should be calculated on a ‘since inception’ basis which is where, at any point in time, an individual investor has paid a fee based on the value added to his specific investment over the entire period that it has been managed. This method tends to emphasise long-term performance over short-term performance and ensures that investors pay fees on precisely the performance they have received.

“Alternative methods can mean that short-term performance may be rewarded even when long-term performance has been poor and vice versa,” says de Lange.

However, it is practically impossible to calculate and administer a ‘since inception’ performance fee across large numbers of unit trust clients, so compromises have had to be found. These include various ‘rolling calculation periods’ and the use of ‘high watermark’ structures in performance fee structures, both of which have certain advantages and disadvantages.

Fee could be zero percent

A rolling calculation period is where performance fees are charged based on a certain number of years’ performance. In the Allan Gray Equity Fund, as an example, the performance fee is based on a two year rolling period. The fund carries a base fee of 1.5 percent, which is payable for benchmark performance. Thereafter, a fee for outperforming the benchmark becomes payable up to a maximum of three percent (for outperformance up to 15 percent above the benchmark). However, if the fund underperforms its benchmark by 15 percent or more, the fee will be zero percent.

By way of example, assume the Allan Gray Equity Fund returned 15 percent over the last two years and its benchmark, the FTSE/JSE All Share Index, achieved 10 percent over the same period. This amounts to an outperformance of five percent by the fund. In this case, the asset management fee would be 2.5 percent.

But say the fund delivered a 10 percent return against a 15 percent return by the ALSI over the two year period. In this instance, the fee would be 0.5 percent.

So there will be times when new investors come into the fund and pay a higher performance fee from the outset — a fee they are effectively paying for historical performance. However, there will also be times when new investors come into the fund after a period of underperformance and pay a lower fee at the outset.

While this may not seem equitable over the short term, De Lange says that over time and with the impact of variations in performance, fees normalise and long-term investors are treated fairly.

What is a ‘high watermark’? It is the highest level of outperformance the fund has reached since the previous fee payment date. What it means to an investor in the context of a performance based fee structure is that the fund manager has to first make up any past underperformance (i.e. reach the high watermark or previous performance level) before a performance fee can be charged.

“We believe that despite any compromises, performance fees are a substantial improvement on fixed fees and our only hesitation would be when it comes to performance fees that use an inappropriate benchmark or are calculated over very short periods of time. This can lead to a manager chasing short-term returns as opposed to focusing on delivering long-term outperformance — the basis of wealth creation.”