Closed-ended UK funds that implement performance fees have comfortably outperformed those which only have straight ongoing charges, according to the latest FE Trustnet study.
Performance fees have become a major sticking point within the industry as while many believe they incentivise the manager to outperform, others view them as further evidence of fund manager greed.
To take a closer look at the debate, FE Trustnet built equally weighted portfolios of all the trusts that are at least 10 years old and charge a performance fee and all the trusts that don’t within the IT UK Smaller Companies, UK Equity Income and UK All Companies sectors.
Of course, while the past is no guide to the future, FE data shows that investors have been better off owning trusts which implement the added fee.
The greatest difference in performance is in the IT UK Smaller Companies sector, with the portfolio of performance fee-charging trusts (which includes BlackRock Smaller Companies, Henderson Smaller Companies and Invesco Perpetual UK Smaller Companies) returning 282.68 per cent over the last decade and outperforming those that don’t charge a fee by 101.97 percentage points.
Performance of composite portfolios in UK Smaller Companies sector over 10yrs
Source: FE Analytics
The IT UK All Companies sector has also seen a drastic difference in performance over the same time frame, with fee-charging trusts returning 208.26 per cent and outperforming the non-fee-charging average by 89.19 percentage points.
These funds include Keystone Investment Trust, Threadneedle UK Select Trust and Schroder UK Mid Cap.
Trusts with performance fees in the UK Equity Income sector have also comfortably outperformed. In fact, as the below table shows, the composite that charges a performance fee outperforms the composite that has no fee over three and five years, as well as over 10.
Source: FE Analytics
The data could add fuel to the fire when it comes to the debate over performance fees. While many investors argue that they are being charged extra for a manager to simply do their job, others point out that it aligns interest between the fund manager and the investor. 
Simon Evan-Cook, senior investment manager and multi-asset manager at Premier, believes that it is fund managers’ approach to charging a performance fee that needs to change, as opposed to charging a fee in the first place.
“When performance fees were first talked about, the principle seemed like a good one. However, most of the early incarnations took the “have your cake and eat it” approach, where they kept charging the same AMC, but whacked a performance fee on top of that,” he pointed out.
“From our perspective, the performance fee should work as a discount to the normal charge when the fund underperforms, not an extra charge on top when it does what it was supposed to do in the first place.”
Evan-Cook adds that he has some issues with the performance hurdle used in the fund managers’ calculations, as in some cases it is set beneath the level that fund managers said they expected to achieve when they were marketing the fund.
“In short, we are not really for or against performance fees. It is the overall level of fees that concern us more,” he said.
Another financial expert calling for change in the way performance fees are charged is Dan Brocklebank, who is the director of Orbis Access and Orbis Investment Advisory.
In an article published earlier this year, he told FE Trustnet that, if the current structure of performance fees was re-vamped, they could in fact hold a lot of appeal and in time become something investors couldn’t do without.
Like Evan-Cook, however, he believes this can only happen if fund managers bear the burden of underperformance as well as reaping rewards for outperformance.
“In the UK, we’re surprised at how much of a bad name performance fees get,” Brocklebank said in March.
“They seem to be very poorly received in general. But I think the reason for that is that the performances charges that have been used by the industry have been very poorly designed in the past.”
The two-and-twenty model, which is what many investors instantly think of when the term ‘performance fee’ is mentioned, is a technique that is typically adopted by hedge fund managers in which they charge a flat 2 per cent of total asset value as a management fee and add on a 20 per cent charge to any profits made.
Could this perception be changing, though?
According to data released today by Henderson Global Investors, 56 per cent of 1,000 investors surveyed think performance fees are in fact a good incentive for fund managers to perform well while only 19 per cent are deterred from investing by them.
However, two-thirds of those asked were indifferent to performance fees and admitted that, if they had access to past performance data, the existence of a performance fee wouldn’t impact their decision to invest.
Andy Parsons, head of investment research at The Share Centre, says that investors should always familiarise themselves with the finer details around costs and charging.
“Henderson’s research reveals that despite efforts from the investment industry, there continues to be a need for greater clarity and education around the application of performance fees. We do not believe that the addition of performance fees to an investment should be seen as a barrier to investing,” he argued.
“Given the way that these rewards are structured, investors should always feel reassured that the risk and returns are aligned to their expectations. Provided these are achieved or exceeded, any form of bonus payment to the manager should be seen as acceptable.”
Parson’s view correlates with the research completed by FE Trustnet, which shows that there is indeed a difference in performance between those that charge a performance fee and suggests that it does align both investor and fund manager.
The fund that charges a performance fee and has done particularly well in the UK Equity Income sector is Perpetual Income and Growth Investment Trust, which has three FE crowns and is £994.6m in size.
Over FE Alpha Manager Mark Barnett’s tenure, the fund has returned 490.3 per cent and outperformed its sector average by 315.67 percentage points.
Performance of fund vs sector over management tenure
Source: FE Analytics
The trust is also second place out of its 25 peers in terms of performance over five and 10 years.
Barnett receives a base fee of 0.6 per cent on the first £500m of AUM and 0.4 per cent thereafter. A further performance-related fee is payable to the manager in arrears if the trust outperforms the FTSE All Share – this fee can’t exceed 0.5 per cent of the value of the trust’s net assets.
In the popular IT UK Smaller Companies sector, the five FE Crown-rated Strategic Equity Capital trust has achieved a particularly strong performance over five years, providing a total return of 361.11 per cent, outperforming its sector average and benchmark by more than double and landing in the top spot for performance out of the 19 trusts in the sector.
Performance of UK Smaller Companies trusts with performance fees over 5yrs
Source: FE Analytics
While trusts such as these may be worth the performance fee according to many investors, Informed Choice’s Martin Bamford warns that this isn’t always the case, and won’t be until the system receives an overhaul.
“The reality of performance fees is they are often too easy for managers to earn and they don't provide a disincentive for poor performance. They can also incentivise riskier behaviour on the part of fund managers,” he said.
“Investors can already reward good performance by allocating more to a fund or punish poor performance by switching to a different manager.”
He added: “Before we see the widespread introduction of performance fees, I would prefer to see more consolidation of smaller unprofitable funds and generally lower charges, especially for actively managed funds which are closet trackers.”
