Why we don't like performance fees
As Star Wars' Ben Obi-Wan Kenobi might have said "these aren't the fee structures you're looking for".
Performance fees are a controversial subject. If structured in the right way they can incentivise a fund manager to perform well over the long term. On the other hand inappropriate fee structures reward fund managers for short-term gains, excessive risk taking, and mediocre long-term performance.
Hargreaves Lansdown is broadly against performance fees on funds. In most cases they favour the fund manager and do not align their interests with those of their clients.
The £30 million Eclectica Absolute Macro Fund, managed by Hugh Hendry, recently announced changes to its fee structure, including plans to start charging a performance fee. This planned change is a good example of a fee structure we do not like.
When is a fee cut not a fee cut?
From 1st February 2016 the fund will cut its annual management charge, from 1.25% to 1% on the C class. This should reduce the ongoing charges (which include other expenses such as administration and trustee fees) from 1.35% to around 1.1%.
At the same time the fund will begin to charge a performance fee of 20% of ANY positive performance above the 'highwater' mark (see below). The reduced annual management charge will go some way to offset the effect of the new performance fee, but these two changes to the charging structure combined mean Eclectica stand to earn higher fees provided it can deliver more than 1.25% a year for clients.
The performance fee will be payable on 31st December each year and investors will receive none of it back no matter how badly the ensuing year might go. We believe this 'crystallisation' period should be longer than 12 months and ideally at least 36 months. This is to make sure managers are not paid (potentially large) performance fees for short-term, ephemeral, gains.
The devil is in the detail
There is to be a 'highwater' mark in place, which is intended to ensure only returns above previous gains get charged a performance fee. That is, if the fund charges a performance fee then loses its clients' money they should not be charged a performance fee again as the manager recoups those losses.
However, performance fees are complicated and the devil is always in the detail. The small print on this fund makes for ugly reading. Eclectica will be able to request the highwater mark be reset (downwards) if the fund loses more than 30% of its clients' money in any given year. This would then allow Eclectica to receive a performance fee for giving clients their own money back, in addition to the 1% annual management charge, during the next year.
What this means for investors
An unremarkable 6% gross return (after costs and expenses) would mean Eclectica receives a 1% flat annual management charge plus a further 1% 'performance' fee (equal to 20% of the remaining 5%) and the client would be left with 4%.
Under the old fee structure clients would have been left with 4.75% (6%, less the 1.25% flat annual charge), which might not sound significant, but over time it really adds up. Another way of putting it is that charges (including the performance fee) would rise to around 2% under the new structure, from 1.35%.
To illustrate the potentially significant negative impact of the highwater mark being reset downwards, imagine the fund fell in price from 100p to 70p one year. No performance fee would be due (though Eclectica would still get the flat 1% annual management charge), but the highwater mark could be reset to 70p. If the price rose back to 100p over the next year (a gain of approximately 42.9%) Eclectica would receive this 1% flat annual management charge plus a performance fee of around 8.4% (20% of the remaining 41.9% gain). Before fees investors would be no better off than two years previously, but after all fees had been taken they would still be sitting on a loss despite Eclectica potentially earning almost £3 million in fees.
Performance fees can be justified in certain circumstances, but this fee structure combines all the negative elements of performance fees (for the fund's clients) and none of the positives. We feel the 1% flat fee is too high in conjunction with this performance fee structure, while the annual crystallisation period is also too short. We also prefer there to be a hurdle in place which must be met before a performance fee becomes payable, rather than a fee being payable on any positive performance. Finally, a highwater mark that can be reset downwards just seems bizarre and taking the theory to its ultimate extension could incentivise the manager to lose money in order to make it easier to earn fees in subsequent years. We can only hope investors are not fooled into acceptance of this fee structure by any Jedi mind tricks.