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Can these fund charges really be justified? IN a time of economic hardship and stock market volatility and when fat cat bonuses are under tough scrutiny, you have to question the growing trend among fund managers to introduce performance fees on their funds. IAN LOWES takes a look.


PERFORMANCE fees are contingent charges that are levied if a fund outperforms a specified benchmark or 'hurdle rate' and they are charged in addition to a fund's annual management fee.

This may be on top of any initial charge for investing in the fund in the first place - typically 5%, although investing through an IFA or one of the investment platforms often can reduce this figure.

Performance fees on retail funds have a relatively short history in Britain. It was not until April 2004 that the Financial Services Authority lifted its ban on the use of such charges by funds such as unit trusts and Oeics.

Since then, there has been a steady trickle of new funds using these charging structures but more recently there has been a noticeable increase.

Hedge funds have employed performance fees for years. They tend to impose what is termed '2 and 20' - ie a 2% annual management fee (AMC) on the assets under management and an additional 20% fee charged on gains that the fund achieves.

So, if a manager achieves returns of 15% over one year, the fund will receive an additional 2.6% in performance-related fees, which added to the AMC gives a total management charge of 4.6% for the year. In this case, the fund investor will receive a return for the year of 10.4%.

In implementing these on their ordinary retail investment funds, fund groups are arguing that such charges reward the skill of individual fund managers, better align manager remuneration with the goals of the investor and encourage them to move away from the relative safety of targeting the index or benchmark. However, critics say they encourage risk-taking, or are simply a ploy to boost profits at the expense of the investor. The companies that analyse performance data are naturally interested in these developments. Lipper is one such fund performance specialist and its head of consulting, Ed Moisson, says that a big drawback claimed for performance fees is that the way some are structured can mean a manager is rewarded almost regardless of performance. Moisson says virtually all performance fees in Europe only have an upside (ie, there is not an equivalent fee deduction when a fund underperforms).

The problem for investors - and possibly some financial advisers as well - is that the performance fees can be very complicated, with the result that their full impact may not be immediately or fully obvious.

However, their impact can be very substantial indeed. For example, if a fund has a performance fee of 20% of all returns and its value rises by 30% over one year, then the performance fee charged for that year will be 5.7%.

In another scenario, if a fund only has to outperform an index to start levying performance fees and that index is falling, then it may generate those fees when investors are losing money.

The Fidelity China Special Situations investment trust, launched in April 2010 and managed by leading fund manager Anthony Bolton, carries a performance fee of 15% of any outperformance of its Net Asset Value (NAV) over the MSCI China Index, plus a hurdle rate of 2%. There is also a performance fee payable in any one year equal to 1.5% of NAV and any outperformance above this cap will be carried forward.

With a manager of Bolton's renown many may see a justification for performance fees on his new fund and be willing to pay them on the basis that they are likely to see decent returns (although as we all know, past performance is no guarantee of future returns).

The fact that Fidelity has said if the fund underperforms the hurdle rate in any year, this underperformance must be made good before any further performance fee becomes payable, makes this fund's charging structure fairer for the investor than many in the market.

Can performance fees be justified? There are some who will say yes, if the fund manager consistently delivers outperformance. Others will argue they are paying an annual management charge with the expectation that the fund manager is there to make them money so why should they pay more if he or she meets that expectation? With so many funds to choose from in the market, although not as many decent fund managers, ultimately it will be a matter of personal choice and financial advice.

Ian H Lowes is managing director of Lowes Financial Management in Newcastle
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Title Annotation:Features
Publication:The Journal (Newcastle, England)
Date:Jul 24, 2010
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