Making sense of fee structures can be like jumping through hoops.
Deciphering complex fee structures can be like jumping through hoops, writes John Collett.
A report by investment researcher Morningstar shows some fund managers have performance-fee structures so complex, they are likely to bamboozle investors, leaving them unable to compare fees and, worse, paying more than if they had flat percentage fees instead.
''There is no standard way to present the fees and it makes it difficult to make like-for-like comparisons,'' says Tom Whitelaw, a senior research analyst at Morningstar and lead author of the report.
But fund managers argue that performance fees better align the interests of fund managers and investors.
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The Morningstar report's ''Best practices in managed fund performance fees'' shows funds with performance fees also charge a flat percentage ''base'' fee that is usually no lower than the flat fees commonly charged by other managers. In other words, some funds could be said to be double-dipping on their fee take.
The typical performance fee for an Australian shares fund is between 15 per cent and 30 per cent of the fund's returns in excess of a benchmark.
Funds investing in Australian shares will typically have the sharemarket return - measured against the performance of the biggest 200 or 300 companies - as their benchmark.
Importantly, they will also have a base fee - usually just under 1 per cent, though some are much lower.
Morningstar modelled returns over the past 10 years. It used the actual performance of Australian shares during that period and the average return of the three best-performing Australian funds. The modelling assumed a performance fee of 20 per cent on returns above the fund manager's benchmark on an initial investment of $100,000.
The modelling found that over the decade, investors would pay total fees of 3.82 per cent on the most expensive fee structure and 0.97 per cent on the cheapest - a difference of $65,763 between the two funds.
Bar too low
The Morningstar report on 18 Australian share funds with performance fees found several instances where the way the fees were structured could work to the disadvantage of investors.
The single biggest problem identified in the report was a low benchmark against which the performance was measured and the performance fee paid.
One of the share funds with performance fees covered in the report had a benchmark of zero.
In other words, the manager took 20 per cent of returns above zero. The fund also had the highest base fee - 1.09 per cent - of the 18 funds.
''We do not consider the absolute benchmark approach to be best practice,'' Morningstar says. ''It is not [in] investors' best interests to reward a fund manager that can take advantage of a rising market and charge performance fees irrespective of whether or not the fund manager outperforms an appropriate market index.''
The report did not identify the fund but Weekend Money has ascertained that the fund manager referred to is the Sydney boutique fund manager PM Capital, which was funded by Paul Moore in 1998.
Its Australian Opportunities Fund has a benchmark of zero and a base fee of 1.09 per cent.
Moore says the fee structure is different to other funds because it manages money differently. Most managers have portfolios that do not differ much from the composition of the sharemarket, ensuring that their returns are similar to the market.
''We are investors, not index managers,'' Moore says.
The good performance of his fund justifies the fees, he says. Since its inception in 2000, it has returned 230 per cent, after fees, compared with the return on Australian shares of 145 per cent during the same period. ''Investors will make up their own minds whether the fee structure is fair and reasonable and, if they think it is not, they will take their money away,'' he says.
The PM Capital Australian Opportunities Fund has a ''high-water mark'', which means any earlier losses have to be recovered before the performance fee can be charged, whereas two of the 18 funds do not have high-water marks; meaning they do not have to first recover money lost before they can charge a performance fee.
If the performance is measured every 12 months, for example, managers without a high-water mark could underperform the benchmark in one year - making big losses for investors - while taking performance fees the next year.
''A high-water mark is necessary in any performance-fee structure,'' Morningstar says. ''We believe that performance-fee structures that operate without a high-water mark act against the best interests of investors,'' the researcher says.
Regulator
Morningstar says the lack of consistency in performance-fee structures stems from the lack of any clear regulatory guidelines on how the complex components should be displayed.
This makes it much more difficult for investors to compare funds.
The fee structures are so complex, Morningstar found, that even a ''number of fund managers also appear not to fully understand all the implications of their performance-fee structures''.
To protect themselves against being charged too much, investors need to make sure that any performance fee is benchmarked to an appropriate index, Morningstar says. They need to look for a low base fee because it is a constant cost, regardless of performance.
Well-structured performance fees should include a ''hurdle'' that the fund has to outperform in addition to returns of the Australian sharemarket before a performance fee is paid. ''Ensure that the fund manager has to beat a reasonable hurdle before starting to accumulate performance fees,'' Morningstar says.
Tough line balances the ledger
Regulators in the US have taken a tough line on performance fees.
If a fund manager in the US wants to charge a performance fee, it must be a "fulcrum" fee.
If the fund outperforms its benchmark, the investor pays the fund manager the agreed performance fee.
But if the fund underperforms the benchmark, the same calculation occurs in reverse and the management fee is then reduced to account for the underperformance.
An analyst at Morningstar, Tom Whitelaw, says this is the fairest type of performance fee.
Another advantage of a fulcrum fee for investors is that it is simple to understand and makes redundant the "high-water marks", "hurdles" and "resets" of performance-fee structures of Australian funds.
Morningstar says it appears US fund managers do not have much confidence in being able to consistently outperform investment markets because, after the introduction of the regulations in the US that make it mandatory to use fulcrum fees, the number of funds charging performance fees dropped dramatically.
Whitelaw says there needs to be a standard way performance fees are disclosed in Australia so investors can easily compare the different fee structures.
http://www.smh.com.au/money/investing/performance-fees-catch-investors-20110506-1ecgf.html#ixzz1MTDQN8u6
