Performance Fees: Are we really rewarding skill?

Performance fees are great right? In theory if the fund manager managing your money beats the index that you could have invested in yourself they should be able to reward themselves for doing so. This is a big incentive for these fund managers as the better they do against the benchmark the more money the company will bring in and the more they will pay out in bonuses come year end.

In this sense you are both winning, they are helping you get more money than if you had invested passively (which is sadly a very rare case), and they are increasing their own profits. There are however a few (actually many) issues with this process which is resulting in fund managers hedging this process into their favour, and away from the investors favour:

What is their benchmark?

Looking around at some of the biggest equity funds in the market I noticed something a bit crazy. All of them and I mean all of them that I looked into, which were classified in the same category (SA General Equity), all had different benchmarks to which they were competing against. This means that they are all measuring themselves in a completely different way as to whether they perform or not.  

Asisa Category
South African – Equity – General
Shareholder Weighted Index (SWIX)
South African – Equity – General
ASISA South African - Equity - General Category Mean
South African – Equity – General
South African – Equity – General category (excluding Allan Gray funds)
South African – Equity – General
FTSE/JSE Capped All Share Index (CAPI)
South African – Equity – General
FTSE/JSE All Share Index
South African – Equity – General
South African – Equity – General
87.5% FTSE/JSE All Share Index (ALSI) + 12.5% MSCI AC World NR (ACWI) (ALSI pre 15/07/2016)

I have always considered the benchmark for pure equity funds to be the JSE ALSI (the same one that the Foord Equity Fund is benchmarking against (other common ones being the top 40 or the SA DSW)) and that is the benchmark I refer to when I say that fund managers hardly ever beat the index. The fact that they are able to choose what their benchmark is, is already scary enough, and no wonder I was confused when on every single fund it showed that they beat the benchmark consistently. Let’s not even go into the funds that have inflation or CPI as their benchmark.

They beat the benchmark but not after fees

It is no use beating the benchmark (or their version of the benchmark) and charging us normal fees plus additional performance fees, if after these fees we are actually worse off that the benchmark we are trying to beat.

Let’s assume the fund manager has an equity fund that gives a total return for the year of 16%, and their benchmark the JSE All Share Index gave a return of 15%. They charge 1.5% per annum in fees for this fund and add additional 0.2% in performance fees for each percentage point of over-performance. With these charges they will end up charging us 1.7% in fees for the year.

This means that after these fees have been taken from our investment we actually didn’t beat the benchmark we had originally set out to. We would have received a return below the benchmark on normal management fees alone but to rub even more salt into the wounds they are rewarding themselves with performance fees.

Another factor to point out is that quite often if they are performing against a proper index are they not taking dividend returns into account. This can have a significant effect on performance and it surely can’t be fair to quote your own returns with dividends reinvested but not do the same for the index being benchmarked. Hedging more, more and more in their favour.

The benchmark performed poorly

We will quite often see that when the benchmark is performing poorly that more active fund managers during this time are able to out-perform it. However the nature of performance fees means that even if the fund manager performed poorly (in this case poorly means gave us a negative or flat return), but still beat the poor performing benchmark, we are charged a fortune in fees for an overall bad year in the market.

They charge endlessly more for over-performance but not endlessly less for under-performance

There are many variations of performance fees out there, some more complex than other, some more in the interest of the customer but most lie heavily in the interest of the fund manager.

See Allan Gray’s performance fee policy on their Equity Fund below:

This policy allows for minimum fees of 0% and if the fee would have been negative as it states no fee is charged until all under-performance has been recovered. This is an example of a more complex performance fees policy that I feel takes the customer into account more than others in the market. Unfortunately very few do this.

In doing this research I found that most companies do it either one of two ways: they will have a minimum fee much greater than 0% so regardless of their under-performance they minimise their risk by capping the impact of their under-performance on their income, or they will have a performance fee which can only charge you more for over-performance but not give you anything back for under-performance. The latter must be avoided at all costs.

The simple fact is that because it is so unlikely for fund managers to beat the proper equity index (the JSE All Share Index) I think they would be very scared to implement a performance fees policy which will cause them significant damage to their profits. This is why we see so much cloaks and mirrors in this area and this is why we see them employing tactics ensuring that they beat the benchmark at all costs (like changing what the benchmark is). We as investors need to critically analyse these factors when choosing a business we will be pouring our hard earned money into.

Here is an extract from a moneyweb article showing how unlikely it is for fund managers to beat the benchmark they compete against:


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