Competitive pressure from the passive sector, continuous lobbying from consumer activists and regulators criticising active managers for taking too much in fees have forced firms to rethink models. Many claim that most, or at least average, fund performance is below benchmark returns, mainly down to the fees charged for the privilege.
Early last month, Fidelity International announced that it was going to reduce its base management fee and introduce a ‘fulcrum fee’. This is a kind of performance fee that means it will return money to investors if the fund underperforms its benchmark.
Its related – but separate – company, Fidelity Investments, has established a similar process in the US, where it has trillions of dollars under management, and where most of its mutual funds have performance fee adjustments.
In the UK, however, much remains to be clarified in terms of how much Fidelity International will reduce the base management fee, and what the fulcrum fee will consist of. In addition, as part of the announcement, the fund manager said it would still be charging investors for external research costs, unlike most of its rivals, and that the reduced fee and fulcrum fee would apply only to a new share class.
The fulcrum, or variable management fee, is rather unusual in the UK investment industry. No other mainstream fund manager offers one, so it is something UK investors and their advisers will have to take on and understand.
Key Points
Fidelity International has announced the launch of a 'fulcrum' fee for a new share class
Fidelity Investments in the US has been operating a variable management fee on most of its funds
Much needs to be explained by Fidelity International in terms of how it will operate the fulcrum fee
Sliding scale
In the statement, Fidelity International said: “The variable management fee operates as a sliding scale and acts as a two-way sharing of risk and return. Where we deliver outperformance net of fees, we will share in the upside. In the event that clients experience benchmark-level performance or below, they will see lower fee levels under this new model.
“The fee clients will pay will sit within a range and will be subject to a predetermined cap (maximum) and floor (minimum).”
Christopher Traulsen, Morningstar director of ratings, agreed with the general principle of the policy. He said: “I do think they’re showing that they’re trying to align their interests with investors, but it’s come short on detail. It’s very hard to make any judgement on it at this point.
“I think investors are better off with a low-cost fund, and no performance fee at all. [But] if you’re going to have a performance fee, a fulcrum fee can be a better way of doing it.”
Much needs to be released about how the charges on the new share class will be calculated, and how it will compare to other funds and other Fidelity share classes.
Mr Traulsen said: “If they continue charging a base management fee that’s the same as the rest of the market, then it’s unfair. You shouldn’t need extra incentives to drive outperformance. They need a lower fee than their competitors in the market in order to justify that structure.”
In the US, Fidelity Investments’ fulcrum fee operates on a basis of moving plus or minus up to 20 basis points on the annual management charge (AMC), depending on how the fund compares against the benchmark, over a rolling three-year period.
Of the UK company, Laith Khalaf, senior analyst at Hargreaves Lansdown said:“It depends on what level the Fidelity charge is set at. For example, if it’s a 0.75 per cent annual management charge, and they give back 0.2 per cent because they underperform, then you’re paying 0.55 percent for underperformance.You can get a tracker for [alot less].”
A statement from Fidelity said: “This is a fundamental change to our charging model, so it will take time to fully implement. We will be working closely with our clients in the coming weeks and months to explain and implement the model.”
Performance fees
Some funds in the UK operate a more conventional performance fee, such as an extra 10 per cent when the fund outperforms the benchmark, but gives nothing in return if it underperforms.
Charles Younes, research manager at FE, suggests that the concept of using such simple performance fees on basic equity strategies does not bear contending with. He was more positive towards Fidelity’s model, however.
He said: “Some long-only funds are charging performance fees for investors. It’s unfair: they charge clients more when they outperform, but not less when they underperform.”
Daniel Godfrey, non-executive director of Moneybox, believes that performance fees do have a place, especially when the fund is restricted in size owing to the specialist nature of the investment. He said: “The time when I think performance fees really make sense is if you’re capping the amount of funds under management. If you can only manage £100m, then the fund manager is constraining the size of the fund and, therefore, the basis on which they can earn a fee. In those circumstances, they can ask for a performance fee.”
“There’s no single performance solution,” Mr Godfrey added.
Boutique outfit Orbis Investments operates a similar system to the Fidelity proposal. Its chief executive Dan Brocklebank believes that Fidelity’s iteration of the performance fee is a good solution. He said: “Performance fee structures have developed a lousy reputation over the years, thanks in part to the flawed “heads we win, tails you lose” structures. In addition to their PR issues, [they] face a number of obstacles to make them work well in practice.
“From an operational standpoint, they are muchmore complicated for managers to implement and for investment platforms to accommodate. Understandably, some clients prioritise the predictability that comes with paying a steady flat fee. Communication can also be an issue. Performance-linked fees can be much harder for clients to understand and there is ample room for misunderstanding.”
Aside from all of this is the question of research costs. Under Mifid II, investment firms are no longer allowed to pay for external research and transactions together (see page 48). The unbundling of these services by brokers has meant fund firms need to decide who pays for the external research element used in stock and security selection; the investor or themselves.
Research charges
Many have decided they will simply absorb the cost of research, but Fidelity will still pass this on to clients.
A statement from Fidelity said it would adopt a system where investors are charged and will fund the cost of all external research. However, it said the reduction of its base fees under the fulcrum share class would be greater than the extra cost of research.
A research note by Mr Traulsen and his colleague, Jonathan Miller, criticised this decision.
They said: “The point of paying a premium for active management is because one expects the manager to produce research sufficient to enable outperformance. We believe fund firms should pay for external research out of their own pockets (already funded by the active management fees investors pay).
“To pass the charge on to investors strikes us as being charged twice for the same service.”
Melanie Tringham is features editor of Financial Adviser
