‘The problem with performance fees is that investors only complain in two instances – when they don’t pay performance fees, and when they do!’
Anonymous industry veteran
‘The psychologist Gerd Gigerenzer has a simple heuristic. Never ask the doctor what you should do. Ask him what he would do if he were in your place. You would be surprised at the difference’
Nassim Nicholas Taleb, Antifragile: Things That Gain from Disorder
One of RECM’s founding principles is that of directly aligning our interests with those of our clients. It’s been mentioned frequently in these pages that we’re significantly co-invested alongside our clients – paying exactly the same fees. When we allocate capital to an idea, we’re investing our own money alongside that of our clients. When our funds are doing well, we feel much more than the warm glow of professional satisfaction, we benefit financially from the growth in our own capital. And in periods of underperformance we feel the pinch as much as our clients.
This philosophy carries over into our approach to the fees levied on the funds we manage.
Fair and effective implementation of performance fees is surprisingly challenging
While the concept of a performance fee is reasonably straightforward to explain and understand in general terms, and has a strong emotional appeal to investors, in practice it’s actually deceptively hard to implement in a fair way. This is especially true in the case of open-ended/unitised investment vehicles such as South African unit trusts. The many ways of calculating performance fees are limited only by the number of spreadsheets that can be built.
If performance fees are calculated over a period which is too short, then fees could be levied on performance that was not a result of the managers’ efforts, but from random short-term market movements. So too, the investor runs the risk of a ‘heads I win, tails you lose’ situation when performance fees are collected immediately after outperformance, but not given back in periods of underperformance. Fees calculated over so called ‘rolling’ periods have the drawback that recent investors could be charged fees for returns that accrued to the fund in the past, but not to their investment.
Here at RECM, we feel very strongly about ensuring that our performance fee methodology best aligns our interests with those of our clients. We charge a fair, flat-rate annual fee for managing a fund and only receive a reward in the form of a performance fee for delivering sustained outperformance. To this end, we’ve designed our methodology around several fundamental principles.
- We only charge a performance fee on the actual performance that each individual investor has received.
- We only receive a performance fee if we’ve managed to outperform an appropriate benchmark by a sufficient margin over a long enough period.
- Performance fees are accrued from the fund and held in a separate account for a period of five years. Accrued fees are refunded to investors from this account should subsequent periods of underperformance occur.
- As the RECM Global Flexible Fund aims to grow investors’ wealth in absolute terms, we don’t charge our investors a performance fee if their investment value is below the original invested amount, or the highest previous value. This is what’s called a high watermark principle.
This methodology was introduced on 1 April 2011 and despite our general approach of keeping things simple, we find that when building the above approach into our performance fee calculation, it takes a little explaining.
How RECM calculates performance fees
We levy performance fees on the RECM Equity Fund and the RECM Global Flexible Fund. To keep things simple, I’ll explain the calculation as it relates to the RECM Global Flexible Fund. The calculation for the RECM Equity Fund is similar, but uses the JSE All Share Total Return Index + 2.5% per annum as the hurdle rate.
- Performance fees are calculated daily, based on the change in the fund’s net asset value compared to the day before. This calculation includes both realised and unrealised investment gains or losses, as well as income accruals. The calculation excludes movements due to new fund inflows or withdrawals.
- When the daily performance of the RECM Global Flexible portfolio beats its hurdle rate, the daily equivalent of SA CPI + 8% per annum, 20% of this outperformance is charged to the Fund and added to the accrual account. If the daily performance is less than the hurdle rate, 20% of this underperformance is returned to the Fund from the accrual account – subject to the accrual account being in a net positive position.
- If the accrual account falls below zero, we keep track of this amount and this deficit has to be made up through future outperformance before any further accruals can be charged to the Fund. This approach is a built-in high watermark.
- At every month end, if the total value of the accrual account (the sum of all the daily accruals) is positive, and the fund has outperformed its hurdle over the prior five-year period, then the performance fees earned in the same month five years ago are paid to RECM.
- If the performance fee accrued in the specific month five years ago is negative then no payment is made.
Performance fees are included in the Total Expense Ratio
Investors can assess the performance fees accrued and added to the accrual account in any twelve-month period from the Total Expense Ratio (TER) published on our fund fact sheets. The TER represents all the fees and expenses, excluding brokerage incurred in transacting in underlying securities, incurred over a certain period. This is expressed as a percentage of the average assets of the fund for that period. The Association of Savings and Investment South Africa (ASISA) guidelines require the TER to be calculated at every calendar quarter end for the preceding 12-month period. The performance fee component of the TER is split out separately.
To give a better understanding of the long-term effect of performance fees, we also disclose a TER calculated from 1 April 2011 in our fact sheets. In the latest fact sheet to 31 March 2014, the 12-month figure for the RECM Global Flexible Fund Class A Units is 4.56%, and 2.98% for the period since April 2011 – both inclusive of VAT.
Over the 12 months to March 2014, the underlying portfolio of the Global Flexible Fund returned 28.0% before fees and 23.7% after all fees. The hurdle rate of return for the period was 13.9%. The underlying portfolio therefore outperformed the hurdle rate by 14.1%, which led to a performance fee of 3.2% including VAT.
From April 2011 to March 2014, the underlying portfolio of the Fund returned 20.36% per annum before fees and 17.4% per annum after fees. The hurdle rate of return for the period was 14.0% per annum. The underlying portfolio outperformed the hurdle rate by 6.36% per annum, which led to a performance fee of 1.45% including VAT.
As an aside, you’ll have noticed that adding our Annual Fee (1.4% including VAT) to the above performance fee calculations does not get you the TER. The small difference arises from the administration expenses – such as bank charges and audit fees – as well as the effects of rounding and compounding on the comparison of a ratio (TER) to the ongoing daily performance fee accural.
Both of these calculations illustrate the performance fees that were accrued for the relevant periods, but since the calculation period is less than five years, to date no fees have been paid from the accrual account to RECM. The full accrual account is therefore still available to refund investors in an event of future underperformance.
The performance fee methodology is captured and explained in the Trust Deeds of the funds, which are lodged with the FSB and are available to investors in the funds. RECM’s Unit Trust scheme auditors, EY, sign off on the methodology and the calculations every year as part of the funds’ audits. A copy of the latest set of accounts is available from email@example.com.
A principle-based methodology best aligns interests
We believe that the way we calculate performance fees at RECM not only ensures a fair and transparent fee structure, but also optimally aligns our interests as fund managers with those of our co-investors.
Jan van Niekerk