Putting a price on high cost of performance

Putting a price on high cost of performance

Fees are always very controversial, whether for lawyers, estate agents or investments.

They are under more pressure than ever today as a whole range of competing forces step up the challenge to traditional economics: the shift towards passives and exchange traded funds (ETFs), greater transparency and scale buying power on investment platforms such as Hargreaves Lansdown and AJ Bell, and the concentration of manager skill in mega funds like Woodford and fund houses like Blackrock.

Performance has always been controversial too: while it waxes and wanes, excites and disappoints through the cycle, no matter what your investment outcomes the fees you pay are certain, along with death and taxes.

But somewhat paradoxically, perhaps now the time is ripe for a re-evaluation of performance fees and the role they can play in the industry’s drive to offer better investor choice and value for money. Surveys have indicated for some time that consumers would like to have more choice. There are many complexities involved, but maybe active managers could make more alternative charging structures available and investors, or more likely their advisers, would be prepared to do the extra work to find the hidden value.

‘Value’ does need to be the operative word here, as performance fees tend to have offered pretty poor value in the past. Firstly, they tend to be mandatory rather than an option, so if you want the manager and the strategy, the attitude is ‘take it or leave it’. This became the standard procedure and hallmark of the hedge fund industry. Secondly, they tend also to be quite generous in their rewards for performance. The problem with this is twofold: that investors resent paying high fees even when the performance is successful; and fees can still be quite high even without successful performance.

Another reason they have struggled for mainstream acceptance is that they can be difficult to understand. Fees are quite complex to structure in a way that charges for success but not for failure; and so as to function across all performance outcomes as expected over long term horizons. All things considered, performance fees have developed a poor reputation for themselves: complex, opaque, a bit lopsided in favour of managers, and perhaps even greedy and unethical.

So what if performance fee structures represented a better deal for investors? What if they aligned managers’ incentives better with investors’ long term investment outcomes? What if they were available as charging options alongside traditional fixed fee charges rather than one size fits all obligations? How about performance mechanisms where the break even vs the fixed charge option were more closely calibrated to the investment objective? And absolute caps to high performance upside, in inverse proportion to base fee reductions? Could they meet with a more favourable reception, and might they have a more useful role to play?