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By Emma Wall | 08-14-2013 12:01 AM

Ask the Expert: What are Performance Fees?

The first in a new weekly series, we ask Morningstar analysts to decipher the more complicated aspects of investing

Emma Wall: Hello and welcome to Morningstar TV. I’m Emma Wall and you are watching the new series Ask the Expert. Here with me today is Jackie Beard to talk about performance fees.

 

Jackie Beard: Hi, Emma.

 

Wall: Hello, Jackie. So investment trusts known for their low fee structure, but many of them carry performance fees. What is a performance fee?

 

Beard: Well, there’s some key terminology to understanding a performance fee. It’s basically a way of rewarding a manager for performing over a certain amount. So, first of all, you need to look for a hurdle rate. A hurdle rate means they have to outperform a benchmark by a certain percentage before the fee triggers. Then we look for high watermarks, and that basically means that he has to get – he or she has to get back to the highest value they’ve reached before you can accrue performance fee again. So, in other words, we are trying to make sure that you don’t lose a lot of money in a down market, and then making that back up again, you get rewarded for that, because that’s not really a way for things to work. Then we also look for a cap. You can have caps on performance fees, which makes sure that they are not taking widely excessive amounts.

 

Wall: Why should fund managers be paid twice for doing their jobs?

 

Beard: It’s a good question. So rolling back a bit of history; when a lot of these funds were set up with performance fees, they were typically hedge funds. It’s a way for the individual investor to access some of these hedge funds they couldn’t otherwise access back in the ‘90s because of the high minimums, et cetera. It was – so it was a way of allowing them to get into these vehicles, but also to make sure that their manager was going to stay with the vehicle, because managers move around a lot, particularly back at that time there were lot of some (luscious) salaries around, and it was very easy for people to jump ships. So it was way of tying them into that fund as well.

 

Wall: Market circumstances aren’t quite the same now though. So have things changed?

Beard: They have and I think RDR has helped this as well, because one of the key messages we keep hearing on RDR is simplification, and we’ve seen a number of trusts actually remove the performance fees; Securities Trust of Scotland, Standard Life Smaller Companies, Bankers Trust, City of London. They’re really starting to look at it now, and that’s driven as much by the asset manager as by the Board of Directors as well, because people don’t like complications. So we’re seeing that kind of simplification. Will they ever go away? I don’t think so, but I think we get into a much better level now.

 

Wall: From an investor’s point of view, how can I decipher these fees?

 

Beard: You need to make sure that if there is a performance fee that it’s relevant. So, for example, Fidelity China Special Situations trust everybody know is run by Antony Bolton, although he’s handing over next year. Its benchmark is MSCI China, which is relevant to some extent, but actually when you look at Bolton’s style, he’s investing much more in mid- and small-caps, whereas the index is large-cap. So there’s a question over the relevance of that. Likewise, BlackRock New Energy investing in very niche sector, but its benchmark is MSCI World. Again, on that one, it’s very difficult to know what the right benchmark would be, because it’s in such a niche area. But as we’ve said, the trusts maybe just don’t have one, because actually it’s meaningless, and it hasn’t triggered either.

 

Wall: Thank you, Jackie.

 

Beard: Thanks.

 

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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