Should you pay investment trust performance fees?

Investing in funds has never been cheaper. In late 2020, research company Morningstar noted that the average European investor paid “lower expenses than ever before,” thanks in part to the relentless rise of passive funds and greater cost awareness.

UK investors have already benefited substantially from this trend with newer developments bringing further advantages. The arrival of value for money assessments has resulted in many investors being moved into cheaper fund share classes and put additional scrutiny on fees.

Expensive charging structures are, thankfully, being swept away. This includes performance fees, which are increasingly rare among open-ended funds. Yet they are still fairly common among investment trusts. So if you invest in these, working out how performance fees affect overall returns and whether they are fairly structured, should be an important part of your due diligence.

The trusts and funds that charge them

The more specialised a fund or trust, the more likely it is to levy a performance fee. Most private equity investment trusts charge performance fees in some form with, for example, HgCapital Trust (HGT) sometimes charging hefty amounts of "carried interest". Popular “growth capital” names such as Chrysalis Investments (CHRY) can also charge performance fees.

Broker Numis has found that while performance fees are relatively rare among property and infrastructure trusts, trusts focused on other illiquid asset classes do tend to charge them. Examples include music royalty trusts Hipgnosis Songs Fund (SONG) and Round Hill Music Royalty Fund (RHM), and trusts that invest in leasing assets.

Specialist equity funds, from Worldwide Healthcare Trust (WWH) and Biotech Growth Trust (BIOG), to Allianz Technology Trust (ATT), Polar Capital Technology Trust (PCT), some of the metals and mining trusts, certain specialist emerging market equity trusts, and some UK small and micro-cap trusts also fall into this camp. And some names in more established asset classes take this approach including Schroder Asian Total Return Investment Company (ATR).

The few open-ended funds that charge performance fees are mainly in the Targeted Absolute Return sector. While much of the sector has served investors poorly in recent years some of the more reliable funds charge performance fees. Janus Henderson UK Absolute Return (GB00B5KKCX12), which we include in the IC Top 100 Funds, charges a performance fee of 20 per cent on any returns made over the Bank of England base rate, subject to a high water mark.

But performance fees are becoming less common among both open-ended funds and investment trusts. For example, Martin Currie Global Portfolio Trust (MNP) recently dropped its performance fee in favour of a "simpler and more transparent cost structure." And while the fee for this trust's first £300m of assets has risen, it falls for assets above this amount.

What to look for

Extra fees are never welcome, given the extent to which they can potentially erode returns. Yet an obsession with costs alone can pull you away from good investments. While low-cost passives have served investors well, some of the strongest performing active funds are not necessarily the cheapest. Similarly, "expensive" investment trust sectors such as private equity give exposure to areas you couldn't otherwise access and deliver some strong returns after charges.

Performance fees can incentivise a fund manager to outperform. But serious scrutiny should be given to how a performance fee works and whether the investors who pay it are being treated fairly.

It is always important to first consider whether a fund is doing what you want, for example, backing the best names in a sector or providing diversification in an equity-focused portfolio. This question exposes problems with absolute return funds, many of which have offered dismal returns and done little in terms of being a buffer against equity market shocks. Wealth preservation trusts, such as some trusts in the Association of Investment Companies (AIC) Flexible Investment sector, or a selection of diversifying assets may be a better choice.

More generally, a fund should offer something that warrants the extra fee. This could be exposure to a hard to access asset class such as private equity or returns strong enough to justify the investment manager taking another cut.

The exact structure of the fee should be scrutinised closely. Details can often be found in documents such as factsheets, and reports and accounts. Trust performance fees also tend to be detailed in the "charges and gearing" section of a given trust's page on the AIC website.

A few elements are particularly worth checking. A fund should have an ambitious enough target return to trigger a performance fee – simple growth in assets should not be enough. The target could be a high absolute return, a level of outperformance against a relevant market or a level of performance against inflation. Investors differ on which target they think works best: seeking an impractically high absolute return may encourage excessive risk taking while some targets are simply too modest. Darius McDermott, managing director of research company FundCalibre, argues that targets set against benchmark interest rates, for example, are "no longer appropriate." Others, similarly, may question whether inflation is an appropriate yardstick after years in which it has looked fairly tame.

Another important part of the performance fee structure is the high water mark, whereby a manager can only collect a performance fee if the fund exceeds the highest net asset value previously achieved. This prevents a manager from, for example, making a loss and then charging a performance fee if the fund recovers from its lows. Charging performance fees based on short time periods, similarly, can be costly for investors.

One encouraging feature is if a fund offsets the effect of its performance fee with a lower ongoing fee than its peers. Examples include BlackRock Throgmorton Trust (THRG) which charges a performance fee but has a lower ongoing charge than stablemate BlackRock Smaller Companies Trust (BRSC), which doesn't levy a performance fee.

It is also worth checking whether a performance fee is capped and how much is actually charged - some fees can amount to 20 per cent of outperformance or even more. With investment trusts, it can also be a useful incentive if the manager receives the performance fee in the form of the trust's shares.

Simon Moore, founder of consultancy Trust Research, meanwhile, argues that trusts which buy illiquid assets could use the successful sale of holdings as a metric for setting their performance fees.

<Boxout> Examples of a performance fee-only model

Another advantage of just charging an ongoing fee, rather than this and a performance fee, is simplicity, because investors immediately know exactly how much they are paying. A performance fee, by contrast, creates uncertainty over how much will ultimately be charged. However, some trusts have abandoned ongoing fees in favour of a performance fee-only model.

William Heathcoat-Amory, head of investment trust research at Kepler, notes that Ashoka India Equity Investment Trust (AIE) has fared extremely well. Its investment manager charges no ongoing fee but will levy a fee of 30 per cent on outperformance versus MSCI India index over periods of three years. As of 6 May 2021, the trust had delivered a share price total return of 43 per cent since its July 2018 launch, outpacing MSCI India index's 26 per cent sterling total return over that period. Value-orientated UK equity fund Aurora Investment Trust (ARR) also operates on a performance fee-only model.

Variable management fees which can change based on performance, meanwhile, have been introduced by Fidelity China Special Situations (FCSS), Fidelity Asian Values (FAS) and Fidelity Japan Trust (FJV).

A drawback of a performance fee-only structure is that it may prove unsustainable for the investment manager in times of difficulty or if their portfolio, in theory, takes a long time to play out. Neil Woodford effectively used ongoing fees from his flagship open-ended fund to finance the management of Woodford Patient Capital Trust (now called Schroder UK Public Private Trust (SUPP)), which relied on a performance fee. But this trust also experienced various problems unconnected to its charging structure.<Boxout>