11th September 2012
The pro-passive fans say buying into an index will beat a portfolio of active funds because costs are lower and while there are some good managers, there is always the risk they will move, be replaced or otherwise fail to deliver. In any case, those who topped performance tables a few years ago rarely keep their pole position. They have more sophisticated arguments such as the effect of group behaviour on investment choices, better and more easily available information flow making it harder to spot market inefficiencies and inconsistencies, and markets that march in step to the beat of the macro politico-economic drum.
Alpha gets tougher to achieve
All these factors make it harder to come up with "alpha" – the fund manager ability to beat averages without taking on additional risk.
Frequent predictions over the past 20 years that the vast majority of funds would be held passively have so far proved far wide of reality. According to research from Lipper, there is some tracker traction with just over 20 per cent of US mutual funds are now managed passively – the European figure is 16.8%. And that's before counting the seemingly unstoppable march of exchange traded funds.
But the active/passive dichotomy may prove to be the wrong discussion platform. For a significant minority of investors – especially those with larger portfolios – the debate could be elsewhere.
Largely forgotten in the minds of most – perhaps a purposeful amnesia due to their complexities – are the performance fees levied originally on hedge funds but more recently on a number of UK mutual funds and investment trusts, especially in specialist areas such as technology and absolute return.
Two and twenty is not plenty
These adapt the hedge fund standard "two and twenty" model – two per cent annual management charge with 20 per cent of gains going to managers – to create a variety of similar fee structures.
Funds with performance fees say they are essential in incentivising managers to come up with spectacular results. Critics say this merely encourages managers to take high risks as they know that they gain when they are successful but if they fail, they don't have penalties and can still keep the annual fees in line with other managers. So it's a one way bet for them.
Now Lipper has conducted research into the UK mutual fund sector, primarily in absolute return funds where performance fees are most used. The FSA banned open-ended funds from performance fees until 2004.
In a paper Performance Fees: Paying Your Dues?, they analyse the value of these costs.
They find the use of performance fees by Unit Trusts and OEICs has declined in recent years, with the number of new fund launches with these fees falling dramatically while other performance fee funds are closed or merged, due not to fund manager altruism but a reaction to IFA concerns that performance fees offer little if anything to investors.
Adviser scepticism is justified
The Lipper paper backs the advisers. In the Absolute Return sector, Lipper found little difference in results between funds whether with or without performance fees. It measured how funds performed on a rolling twelve month basis – absolute returns strives to produce a positive result over a year no matter what the market conditions. It found the average success ratio for funds with performance fees delivered on this 12-month rolling basis was 62.1%, marginally under the 63.5% for funds without performance fees.
At the same time, those with performance fees exhibited higher risk profiles than those without – a vindication of adviser caution.
These figures which show that the supposed incentives to managers via performance fees make little difference need to be read with the caveat that they measure year on year positive progress – not the actual return to longer term investors.
It remains to be seen whether an investor over a three or five year period is better off in total return terms with or without performance fees although the firm suggestion is that they make little difference to fund manager outcomes.
No evidence of better returns
Lipper concludes: "While around 3% of Unit Trusts and OEICs overall have a performance fee structure, among absolute return funds (including ‘offshore' funds) this figure rises to 63.5%. This shows the influence of mutual funds seeking absolute returns mimicking the fee structures traditionally adopted by hedge funds. Even in the Absolute Return sector investors are not being forced to invest in funds with performance fees, both because a sizeable proportion of these funds maintain a more conventional fee structure, and because funds with performance fees have not demonstrated, on average, that they deliver better returns or lower risk."
It "cannot conclude the use of performance fees will continue to decline" but its research has shown investors and advisers can have a very real influence on fund fees. Performance fees, by contrast, cannot be said to have a clearly positive effect on investor outcomes.
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