With fund costs coming under greater scrutiny, not just in the UK but across wider Europe, many fund managers are scratching their heads over whether to offset the downward pressure on fixed management fees by the addition of, or greater use of performance fees. The big question is to what extent would such a move be accepted by the wholesale distributor community who, to be fair, have had some bad experience in the past?
The short answer is that fund selectors are divided on the point with views ranging from a general distrust of performance fees to a call for the balance of fixed and variable fees to be weighted in favour of the performance element.
There is nothing new about charging extra basis points for superior performance. Once a standard for hedge funds, the practice has become a common feature of the Ucits world over the past decade. But the formula for measuring out-performance has been the subject of criticism; distrust that has built up over the years from past experience of opaque structures and hurdle rates that incur charges on negative performance, or performance that beats Libor by a mere basis point. At the extreme end of the opinion spectrum was a UK IFA who vehemently stated: ‘When a fund has a performance fee that’s linked to Libor – which is 0.6% – and no hurdle rate, I think they want shooting.’ A less violent, but nonetheless adamant view came from a French fund of funds selector, ‘We analyse costs with a scoring system and above all we avoid performance fees because they are not always justified.’ Clearly some advisers will need a very compelling case to short-list funds carrying additional performance fees.
Nonetheless, despite some uncomfortable past experience, there does seem to be a growing acceptance that performance fees have a place in the pricing model of some funds. More interesting, though, is a growing lobby of distributors calling for performance fees to have a much greater weighting in the cost structure of funds. The pro lobby would like to see a new pricing model where the management fee is reduced in favour of a variable fee that is linked to performance. This is an approach that is, they say, better aligned with client’s interests.
All this comes at a time when regulators have a sharp focus on investor protection and are moving, through various regulatory initiatives, to adjust the way advisers are compensated for their work. The RDR commission ban in the UK is the most advanced and as the implementation date looms closer the regulators have begun to hint at a more interventionist approach to fund fees that they believe are excessive. The concept of fiduciary duty to the end consumer has been dusted off and is now being aired as a suitable mechanism to stitch the various stakeholder relationships together. Regulators aside, however, there is no doubt that fund distributors now see charging structures as a differentiator that will become more important as new rules on incentives force change on their business models.
With so much past experience of the use of performance fees in the market it seems trite to highlight the characteristics needed to make such fees acceptable. They should be obvious to everyone and there is clear evidence that many of the larger cross-border brands have succeeded in getting the right balance. But for those that are debating the issue three clear ground rules emerge from the Fund Buyer Focus research. First, and fundamental, is the ‘fair share’ concept; the fee has to be justifiable in relation to the performance offered. Secondly, low hurdle rates and formulae that involve investors paying for negative performance will simply act as a deterrent that could have negative repercussions that are long lasting. Finally, the calculation method and justification must be transparent and not just for the fund selectors. Advisers have to be able to explain these fees to their clients and therefore need a simple rationale.
Alongside the idea of re-weighting the proportion of annual fees in favour of the performance fee element is the view of some, that overall fees should be reduced if performance is negative. This is a path that most fund managers will be reluctant to go down, but it just takes one group to break the mould with an innovative client-focused pricing structure and distributor expectations will quickly adapt.
Whatever the direction of fee trends, one thing is clear, pricing structures are becoming an important differentiator across Europe and asset managers with a large book of third party business will struggle if they ignore the significance of this development.
 Data based on over 900 surveys with fund selectors in ten European countries, conducted over the last 12 months by Fund Buyer Focus