Excellent performance should be part of the deal

Much of the current debate about performance fees is premised on the idea that these fees align the interests of the investors and managers. They don’t. Rather, they skew the investment rewards even more heavily in favour of fund managers.

There is no evidence that fund managers who charge performance fees are more skilful than those who don’t. In that case, any outperformance will be down to the usual factors, most notably luck, and the particular market cycle favouring their chosen investment factor, rather than skill. Levying performance fees then merely allows them to charge a higher fee, should they happen to beat their benchmark or hurdle rate.   

If performance fees did drive the manager’s effort, it would suggest fund managers who don’t charge them aren’t motivated to do their very best. But only the closet index trackers in the industry would subscribe to that.

Other fund managers have a strong incentive to outperform, even without performance fees, as they stand to benefit from personal reputational gains and higher bonuses. It also increases the relative value of their fund and attracts inflows, both of which increase the fund’s income.

From the investors’ perspective, they have already paid for any outperformance. They have the option to earn the market return with a low-cost index fund; instead they have chosen to pay a higher management fee for the possibility of earning a higher return. By adding a performance fee, they are paying twice for the same thing.   

To no one’s surprise, the pay-off is one-sided, because there is no rebate for poor results. Investors lose a portion of the upside but must carry 100% of any underperformance. It is instructive that in the U.S., where performance fees are required to be symmetrical, those fees are rare within mutual funds.

This asymmetry creates an incentive for the asset manager (particularly in the hedge fund industry) to take excessive risk with investors’ money in the hope of earning the performance fee. Fund managers can earn massive fees if they get it right; if this works against them, it is investors who take the full financial hit.

The reality is that the interests of the investment industry are inherently at odds with the interests of its customers. The two parties are in a constant struggle over the same pool of funds, which is the investor’s capital, and the returns earned thereon. Performance fees exacerbate this conflict of interest.   

It serves the industry to keep its customers in the dark, lest they become aware of how such industry practices prejudice them. The asset management industry stands accused of poor transparency and unnecessary complexity which allow its performance, or lack thereof, to go unchecked. 

The 2018 10X Retirement Reality Report, surveying more than one million South Africans, found nearly two-thirds lack trust and confidence when it comes to investing money. That is understandable, because the people who work in the investment industry regularly reinforce the notion that it’s too complicated for regular people. Their bottom line is always, “speak to an advisor”, to find the portfolio (among the many hundreds on offer) just right for them.

Yet the elements of successful long-term saving and investing are astonishingly simple. You do not need a finance degree to secure your retirement, or a ‘professional’ advisor. The truth is that every retirement saver has a similar goal: the best possible savings and investment outcome to, at the very least, maintain their lifestyle in retirement.   

Investors give themselves the best possible chance of achieving this if they follow a diligent savings strategy and if they ignore all the subjective investment beliefs out there and simply adopt three proven investment principles: 

1. Use index funds because index funds beat most active funds and provide superior risk-adjusted returns
2. Pay low fees because each 1% fee saved increases your investment by 20% to 30% over 40 years
3. Invest according to your time horizon. The longer your time horizon, the more you should invest in growth assets, such as shares.

It’s not rocket science. In fact, these principles are so simple to implement, that some retirement funds – such as those offered by 10X – incorporate them as standard features.   

Such simplicity, with the necessary advice already built into the product design, does not serve the industry and its army of helpers. Instead, it tilts the investment pay-off profile in the customer’s favour, giving them a fair share of the return. And measured against the many other more expensive and more complicated options available, it all but guarantees investors an above-average return, without performance fees. 

Steven Nathan
Founder, Chief Executive (BCom, BAcc, CA (SA), CFA)

As the former Managing Director of Deutsche Bank in Johannesburg and London, Steven spent more than 10 years in equity research and corporate finance. He was consistently the top-rated Banks and Life Insurance analyst in South Africa, and was also voted best overall analyst in SA and EMEA (Emerging Europe, Middle East and Africa). During his time as Head of Research, the Deutsche Bank team was consistently rated no.1.

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