Page 60 - Profiles's Unit Trusts & Collective Investments - September 2024

CHAPTER 3

Management fees are quoted as an annual percentage, but in practice they are recovered
monthly or even daily by the fund. A portfolio with a net asset value of R2bn, for example, and an
annual service fee of 1% is entitled to recover R20m per annum in fees.
Given that portfolio values change daily, however, the manager may choose to recover 1/365 per
day, based on the daily valuation. This amounts to around R55 000 per day on a portfolio of R2bn.

Performance Fees
Performance fees, designed to motivate fund managers to focus on fund performance rather than
inflows, have become increasingly popular, not least because they increase revenue for the
management company when good returns are achieved. The calculation of performance fees can be
complex, and care must be taken when looking at performance fees to see if they are fair on investors.
Excluding hedge funds, roughly one in ten of South African retail unit trusts make provision for
performance fees. All hedge funds currently work on a performance fee model, usually at 20% of
outperformance. The influence of this category has been felt in the industry. At least two dozen unit
trusts now have performance fees of 20% of outperformance of benchmark, a model which was
unheard of before the advent of hedge funds. Although most of these fees are capped (notably, a few
are not), investors could still lose up to a fifth of index outperformance (just because of performance
fees) in years where overall benchmark returns are in single digits.
Performance fees typically reward fund managers for outperforming a specified target or
benchmark, often referred to as the fee hurdle. Often the annual fee structure for funds with
performance fees will stipulate a minimum and maximum, the first being the annual fee payable in
the case of under-performance, the latter the cap on the annual fee in the case of outperformance.
The minimum fee may also be referred to as a base fee or fixed fee. Obviously, the most important
factor is an appropriate benchmark – a low performance target favours the fund manager and
disadvantages the investor.
Whether performance fees are beneficial from an investor’s point of view often depends on the
actual day-to-day calculation of these fees. The most popular calculation method applies a rolling
benchmark over a defined period (such as two years). When fund performance is above the fee
hurdle, the fund manager captures a defined portion of the outperformance up to the maximum fee
permitted. If this is calculated daily, the performance fee is charged as long as the fund’s two year
performance exceeds the fee hurdle. Given a fee hurdle of, say, the benchmark less 10%,
performance fees will apply most of the time.
A more stringent calculation methodology, used by a small minority of those funds that apply
performance fees, employs as the fee hurdle a high watermark (ie, the highest level of
outperformance at which fees were previously collected). This system requires the fund to recoup
any under-performance that occurs after fee collection before more performance fees can be levied.
As the ASISA guidelines on performance fees point out, good performance fees should align the
interests of investors and fund managers. Advisors and investors should ask the following
questions when considering performance fees:
Is the benchmark appropriate? A fee hurdle based on an undemanding benchmark may
mean unwarranted fees for the manager. CPI as performance benchmark for an equity fund,
for example, would be inappropriate, as would a straight index rather than a total return
index (TRI) for a dividend fund.
Is the fee hurdle appropriate? A target that is too low (eg, benchmark less 30%) rewards
the fund manager for pedestrian performance, whereas a benchmark that is too high can
cause the manager to take undue risks.
Is a high watermark applied? If not, make sure that the basis on which rolling periods are
measured is fair.
Is the rolling period appropriate? An overly long time frame often prejudices new
investors (who end up paying fees related to historical performance from which they
haven’t benefited) and sees exiting investors escaping performance fees, whereas an overly
short time frame can cause the fund manager to follow riskier short-term strategies.

58 Profile’s Unit Trusts & Collective Investments — Understanding Unit Trusts