Trevor Law: Performance bonuses hit you in the pocket

Aug 27 2010 By Trevor Law

Imagine a situation where you pay your child pocket-money, say £5 per week. Little Johnny or Susie suggests that you should pay them an extra 20 per cent if they are good. You agree: this sort of incentive can’t be a bad thing.

A little later you discover that Johnny has started smoking. This doesn’t come under your definition of good behaviour, but Johnny points out that most of his classmates not only smoke but drink as well. Relatively, he is being good therefore he deserves the bonus.

Later on you discover that Johnny has now started drinking. You decide to withhold the bonus, but Johnny argues that most of his classmates are now taking drugs. He isn’t, so he is still “outperforming” his peer group and worthy of the bonus payment.

Obviously, this is a ridiculous scenario, but it is not far from how some fund managers are behaving with the introduction of more and more funds which levy performance fees.

Research has shown that the number of open-ended funds (OEICs and unit trusts) charging a performance fee has risen from 34 to 81 since the end of 2007. Not a significant number among the hundreds of funds out there, but the trend is definitely up.

A more worrying statistic is that two-thirds of these funds can charge a performance fee for beating a falling index, even if the returns are negative. The equivalent to Johnny getting his pocket money “performance fee” for not taking up drinking.

So, how do performance fees work and how can fund managers justify them?

The traditional charging structure for OEICs and unit trusts is to levy an annual management charge, usually between 1.25 and 1.75 per cent.

To grow their income, the fund management needs to grow the value of the assets under management (AUM) by attracting additional investors to buy units in the fund and/or by investing in stocks that grow in value.

Either way, the individual fund manager will have some sort of bonus built in for increasing AUM and beating an agreed performance target. This does not directly affect the investor as it is part of the fund management firm’s internally agreed remuneration package.

Where a performance fee is levied, there will still be an annual management charge, although it may be slightly lower than for a standard fund.

On top of this, the fund manager will charge a proportion, usually 15-20 per cent, of any growth over and above a pre-set benchmark. So if the fund grows by 20 per cent while the benchmark has only gone up 10 per cent, the investor will get 18 per cent growth while the fund managers pocket the two per cent.