Global Investing

LIPPER: Performance fees and apologies

September 24, 2012

As Britain’s Deputy Prime Minister is finding, apologising when you have let people down is no simple matter. The worry for some absolute return funds must be that they are heading for a similar fate to Nick Clegg (even if they’re unlikely to suffer the same level of autotuned mockery).

One of the reasons for the rise of absolute return funds – those seeking to deliver positive returns in all market conditions – is that the industry has been trying to deal directly with client expectations left shattered by the financial crisis.

On top of their investment objectives, one way that absolute return funds say they have tried to better align investor and fund manager interests is by the use of performance-related fees, paid as a proportion of a fund’s returns, not a fixed percentage of assets (although pretty much all funds will charge the latter fee too). But do performance fees actually help to deliver more consistently positive returns, and do they do this for lower levels of risk? Or, much like making ill-advised promises about tuition fees, do performance fees actually make it more likely that a fund manager will have to say sorry down the line?

In the IMA’s Absolute Return sector (established in April 2008), 63.5 percent of funds have a performance fee structure in place. That contrasts with about 3 percent for all UK-domiciled funds.

Because funds in this sector are managed with the aim of delivering above zero returns on a rolling 12 month basis, it is this that has been used to compare their performance. Each fund’s performance was calculated at monthly intervals, looking at a 12-month period for each interval (up to the end of July 2012.

As a result, the data does not reflect a simple snapshot of how absolute return funds have performed over any one period, but instead gives a more detailed view of their ongoing performance since the inception of the sector (or since a fund’s launch, if later).

Using this measure, we can show that funds with performance fees delivered positive returns 62.1 percent of the time, while their peers with a more traditional fee structure managed it 63.5 percent of the time.

A summary of the funds’ absolute return performance is shown below:


RETURNS AND RISK

In the chart, funds are put into three groups: those achieving positive 12-month rolling returns less than 50 percent of the time, those achieving this between 50 percent and 74 percent of the time, and those funds achieving this goal at least 75 percent of the time. The funds are also split between those with and without performance fees.

This shows that funds with performance fees are relatively evenly split between the three performance ‘bands’, while there are more significant differences for those with a traditional fee structure. While the latter have fewer ‘poor’ funds (21 percent versus 31 percent among funds with performance fees) and more ‘average’ funds (46 percent versus 33 percent), the ‘good’ funds make up a fairly similar proportion of both totals (33 percent compared to 36 percent).

A different approach has to be taken when looking at risk. Here two universes of absolute return funds were assessed: funds with at least 3 years history (37 funds, of which 20 have a performance fee), as well as a larger universe of funds with just 1 year history (69 funds, of which 45 have a performance fee).

Both volatility of returns, expressed as standard deviation, and maximum drawdown were calculated. To gain a further level of granularity in this comparison, both the mean and the median was calculated to present average historical risk measures for these funds.

The findings seem to be fairly clear: in seven of the eight comparisons made, funds with performance fees look to have been more ‘risky’, on average, than those funds without performance fees.

But further exploration of historical risk is warranted.

Both standard deviation and maximum drawdown were plotted for each fund over three years, distinguishing between funds with and without performance fees, in the following chart.


This neatly illustrates that 8 funds with performance fees are out of line from the other 29 funds (of which 12 have a performance fee) in their historical ‘riskiness’ (as measured by maximum drawdown and standard deviation).

Quite simply, those funds with historical characteristics that suggest greater risk all have performance fees. This also seems to support the point that a variety of strategies – with different risk profiles – are employed by funds seeking absolute returns.

Absolute return investors in the UK are not being forced to invest in funds with performance fees, both because a sizeable proportion (36.5 percent) of these funds maintain a more conventional fee structure, and because funds with performance fees have not demonstrated, on average, that they deliver better returns or lower risk.

Hugh Hendry, founding partner of Eclectica Asset Management, has gone so far as saying that “It is outrageous that managers with no long/short experience have the audacity to charge a performance fee.”

Clegg’s contrition was for making a pledge in the first place, not for breaking it. And with the sustained scepticism of financial advisers in mind, it’s no surprise that the number of UK fund launches with performance fees attached has declined.

It’s certainly difficult to make out a clear case for the better client/manager alignment that performance fees were designed to bring for absolute return funds. Some will plough on; some might make a good fist of it. But what odds on the poor performers plucking up the courage to apologise?

(Editing by Joel Dimmock) ((joel.dimmock@thomsonreuters.com; Twitter: @reutersJoelD; +44 20 7542 3505))

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