More secrets… not all dirty

I would like to expand on the “Dirty Secrets” published a couple of weeks back.¹  

“Not telling me something or hiding something on purpose is just the same as lying.”

Is your manager “double dipping”?

Some fund managers and brokers have “soft dollar” arrangements, where a proportion of commissions (paid from fund assets) are directed toward paying manager expenses. This can only mean higher brokerage rates than otherwise, but it is considered acceptable industry practice provided it is “disclosed”. Your $500m fund may well be paying an extra $500,000 each year in commissions so that its brokers contribute that amount toward your manager’s operating costs.

Is your benchmark ideal?

This was perceptibly raised in comments after the original piece. Most managers choose a benchmark that reflects the fund’s return objectives. To the extent that this also reflects a fund’s risk profile it makes perfect sense. But what about your long/short equity fund that applies the RBA cash rate, or 0% as its benchmark? Does shorting an equal amount of long equity exposure eliminate equity risk? I suggest not. Does your manager get a “free ride” on equity risk?

Are your manager’s balls on the line?

Performance fees provide managers with asymmetric payoffs. True alignment requires capital at risk. Many individuals running funds are paid millions. How much does your manager invest in your fund?

“When taking a flight, you want the pilot on the plane.” – Leon Levy

Does your fund’s performance fee include a high water mark (HWM), does it increase, can it be reset?

A HWM requires prior periods of underperformance to be recouped prior to future performance fees being paid. Despite being investor friendly, you may like to consider whether your fund’s HWM increases (a Hurdle) and whether your manager has ever reset any of their HWM’s. When you check the details – you may well find yourself invested with a manager that every month, quarter or year is playing a new game of heads I win, tails I don’t lose.

How frequently does your fund pay its performance fee? Are you treated fairly?

I agree with the premise of the original piece (that the less frequently performance fees are paid the less likely investors, as whole, will pay for performance that is subsequently reversed). However to implement this in practice is not simple because the “correct” performance fee will always be different for investors that subscribe at different prices. Accruing it daily does not solve this problem.

Consider the following example of a fund that applies a performance fee of 20% above 0% – and because the manager strives to be investor friendly – it only pays it annually:

• it has a unit price of $1.00 at 1 July 2016;
• having achieved a spectacular return over the first six months, at 31 December 2016 its gross value increased to $2.00 and having accrued a $0.20 performance fee liability, its net value is $1.80;
• it then suffers an investment loss and its gross value falls from $2.00 to $1.50 as at 30 June 2017. A $0.10 performance fee is paid and the remaining $0.10 of the prior liability is reversed, so its net value is $1.40 and the HWM is reset;
• over the next year, it rebounds such that its gross value as at 30 June 2018 is $1.70. It then pays a performance fee of 20% of the $0.30 value over the HWM.  so its net value is $1.64 and again the HWM resets.

For the investor that subscribed at $1.00, their net asset value increased to $1.64, and for that they paid a total performance fee of $0.16.

But let’s say you invested on 1 January 2017 at the prevailing net value of $1.80. How would you feel knowing that despite your investment falling in value by 8.9% you paid your manager a performance fee? And what’s more, imagine it accounted for almost 40% of the decline in your investment! It’s not one-sided. Assume an opposite return profile for those half year periods. You would have been particularly lucky. Not only would you have bought at the low point of $0.75, but because the HWM would have been $1.00, the first $0.25 of your gain would not have incurred a performance fee – you would have enjoyed a “free ride”.

What’s the solution? Perhaps new investors should only subscribe on the day after the performance fee is crystallised (resetting the HWM), or when the unit price is at or below its level when the last performance fee was paid (so you get the “free ride”). Alternatively, if the fund offers it and you are eligible, consider subscribing to a monthly priced series of units issued with their own HWM.

Seen from this perspective more frequent payments are often justifiable. And of course the only way to ensure investors never pay for performance that ultimately reverses is to only pay performance fees on redemption. But it is not reasonable to expect a manager to wait a long and uncertain period before being paid.

Have you considered buy/sell spreads?

Admittedly these observations have negligible impact for long term investors – but buy/sell spreads are not included in performance tables or the “Manager Fees” and fee examples in a PDS – presumably because they are paid to the fund and not to the manager. They are however included in performance fee calculations – so new investors not only incur the spread, they pay their new manager a performance fee related to it!

Conclusion

These are observations I highlight to help investors understand more “industry nuances”. Some are unavoidable flaws, so it is unfair to call them “dirty secrets”. And also let’s remember, it’s what you – the end investor – take home after fees that is ultimately most important.

Be informed,

Stuart and Alexis

¹ https://www.livewiremarkets.com/contributors/lachlan-hughes.