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Pesky incentive fees

Created:
10 September 2008
Written by:
Alistair Blair

Those hedge funds have got something to answer for. Where in the world would you still hope to find undiluted old-style investment management values? In the investment trust sector, that's where. And where are incentive fees taking hold like Japanese knotweed? You guessed it. In the investment trust sector.

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In fact, the first outbreaks occurred nearly 20 years ago. By 2000, a third of trusts had agreed to pay incentive fees to their management companies. Now, 45 per cent of mainstream trusts are affected. These figures come from a report published last month by accountancy firm Grant Thornton. ('Performance fees: a question of purpose'. Download free from the Grant Thornton website.) It is cast in the form of a guide to investment trust directors about the issues that performance fees raise. In a more perfect world, the readership at which it is aimed wouldn't read past the executive summary. But it's an imperfect world.

You wouldn't expect Grant Thornton to be decisively negative about a popular trend in a business sector in which it presumably does a lot of business. But in answering the question, "Are performance fees of advantage to shareholders?", enthusiasm wholly eluded the firm (and its adviser, patron saint of investment trusts, Hamish Buchan). It gave three replies:

"a) That is often far from clear.

b) They can be a one-way option enhancing returns to managers.

c) In themselves they do not make managers perform better."

I do not quibble with performance fees for hedge funds. I question the wisdom of some of those who pay them, but hedge funds achieved prominence by acting for sophisticated investors who wanted their money to be run in unconventional ways and were prepared to pay the price asked, which included performance fees from the very start. No incentive fee, no hedge fund.

By contrast, shareholders in mainstream investment trusts by definition want their money to be run in a conventional manner. And, indeed, it largely still is. So far as I am aware, investment trusts are modest users of derivatives and all but innocent of the practice of selling short. The role of incentive fees in the management of investment trusts is dubious. Is the manager supposed to work harder? Would it make a difference if he did? Is he supposed to take more risks?

No, no and no, appear to be the answers: "The introduction of performance fees did not of itself lead to an improvement in performance or to a material effect on the style of individual managers." Apparently even management companies - the outsiders to whom the management of investment trust portfolios is contracted - acknowledge this openly. Nevertheless, it is clear that the introduction of performance fees stemmed from them.

To add insult to injury, trusts with incentive fees underperformed those without. Grant Thornton studied five-year performance data for 48 trusts. The 24 with incentives beat their benchmarks 53 per cent of the time, whereas those without beat benchmarks 59 per cent of the time.

Perhaps some of this is due to the cost of incentive fees, for even though their introduction normally denotes a reduction in basic fees, performance fees have "on the whole" led to higher fees. I am surprised to see the qualifier "on the whole" in there. As the accountants point out, the introduction of performance fees is asymmetrical, because underperformance and outperformance are equally likely, but the incentive bonus is worth a lot more than the basic fee sacrifice.

So why did investment trust directors say yes to the management companies? The main thinking, apparently, was to help keep good fund managers in their orbit instead of losing them to hedge funds. The remaining 55 per cent of investment trusts who have resisted incentive fees so far will not hold out forever. In any case, the knotweed has already spilled out far beyond hedge funds.

The month before Grant Thornton's report, the Investment Management Association, a club for the UK's biggest institutional investors, reported that out of 61 members who responded to a survey, 51 had agreed incentive fees with at least a proportion of their clients.

Performance fees will surely rise. An admirably detailed appendix at the back of the report sets out in detail every incentive fee agreement in the investment trust sector. For example, if JP Morgan's US small company trust exceeds its benchmark by 2 per cent, the manager collects 15 per cent of the difference. One wonders what they make of that at F&C, whose corresponding trust is currently on an incentive fee of only 5 per cent.

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Read more of Alistair's columns at his IC home page.

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Alistair Blair is a past winner of the Business Writer of the Year Award, and has worked in investment banking and fund management.

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