Should You Pay Investment Trust Performance Fees?
- Open-ended funds rarely charge performance fees
- Performance fees are more common among investment trusts and in some cases may be worth paying
- How to assess whether a performance fee is structured enough
Investing in funds has never been cheaper. At the end of 2020, research firm Morningstar noted that the average European investor was paying “lower spending than ever before”, in part thanks to the relentless rise in passive funds and greater cost awareness.
UK investors have already benefited greatly from this trend, with new developments bringing new benefits. The advent of value-for-money assessments has led many investors to shift to cheaper fund share classes and to exert additional control over fees.
Fortunately, expensive load structures are swept away. This includes performance fees, which are increasingly rare among open funds. Yet, they are still quite common among investment trusts. So, if you are investing in these, determining how performance fees affect overall returns, and whether they are structured enough, should be an important part of your due diligence.
The trusts and the funds that charge them
The more specialized a fund or trust, the more likely it is to charge a performance fee. Most private equity investment funds charge performance fees in one form or another with, for example, HgCapital Trust (HGT) sometimes charging high amounts of “carried interest”. Popular “growth capital” names such as Chrysalis Investments (CHRY) may also charge performance fees.
Broker Numis has found that while performance fees are relatively rare among real estate and infrastructure trusts, trusts focused on other illiquid asset classes tend to charge them. Examples include music royalty trusts Hipgnosis Song Fund (SONG) and Round Hill Music Royalty Fund (RHM)and trusts that invest in the leasing of assets.
Specialized equity funds, from Worldwide Healthcare Trust (WWH) and Biotech Growth Trust (BIOG), at Allianz Technology Trust (ATT), Polar Capital Technology Trust (PCT), some metals and mining trusts, some trusts specializing in emerging market equities and some UK small and micro-cap trusts are also part of this camp. And some names in more established asset classes take this approach, including Schroder Asian Total Return Investment Company (ATR).
The few open-ended funds that charge performance fees are primarily in the Targeted Absolute Return sector. While much of the industry has served investors poorly in recent years, some of the more trusted funds charge performance fees. Janus Henderson United Kingdom Absolute Return (GB00B5KKCX12), which we include in the Top 100 IC funds, charges a performance fee of 20 percent on any return earned above the Bank of England base rate, subject to a high cap.
But performance fees are less and less common among open-ended funds and investment trusts. For example, Martin Currie Global Portfolio Trust (MNP) recently lowered its performance fee in favor of a “simpler and more transparent cost structure”. And while the fees for the first £ 300million of assets in this trust have increased, they are decreasing for assets above that amount.
What to look for
Additional fees are never welcome, given the extent to which they can potentially erode returns. Yet a cost obsession alone can keep you away from good investments. While low-cost liabilities have served investors well, some of the best performing active funds aren’t necessarily the cheapest. Likewise, ‘expensive’ investment trust sectors such as private equity give exposure to areas that you might not otherwise be able to access and offer strong after-cost returns.
Performance fees can cause a fund manager to outperform. But you need to carefully consider how a performance fee works and whether investors who pay it are treated fairly.
It’s always important to first determine if a fund is doing what you want, for example, supporting the best names in an industry or providing diversification in an equity-focused portfolio. This question highlights problems with absolute return funds, many of which have offered mediocre returns and have done little in terms of protection against stock market shocks. Wealth preservation trusts, such as certain trusts in the Association of investment companies (AIC) A flexible investment sector or a selection of diversified assets may be a better choice.
More generally, a fund should offer something that warrants additional charges. This could be exposure to a hard-to-access asset class like private equity or returns strong enough to warrant the investment manager taking another cut.
The exact structure of the fee needs to be closely examined. Details can often be found in documents such as fact sheets, reports and accounts. Trust performance fees also tend to be detailed in the “fees and gearing” section of a given trust’s page on the AIC website.
There are a few things that are particularly worth checking out. A fund should have a return target that is ambitious enough to trigger a performance fee – simple asset growth should not be enough. The objective could be a high absolute return, a level of outperformance against a relevant market or a level of performance against inflation. Investors differ as to which target they think works best: The pursuit of low absolute return may encourage excessive risk-taking when some targets are just too small. Darius McDermott, chief executive of research firm FundCalibre, argues that targets set against benchmark interest rates, for example, are “no longer appropriate.” Others, likewise, may wonder if inflation is an appropriate yardstick after years where it has seemed fairly tame.
Another important element of the performance fee structure is the high water mark, whereby a manager can only receive a performance fee if the fund exceeds the highest previously achieved net asset value. This prevents a manager, for example, from making a loss and then charging a performance fee if the fund recovers from its lows. Charging performance fees based on short periods, as well, can be costly for investors.
One encouraging feature is that a fund offsets the effect of its performance fee with a lower ongoing fee than its peers. Examples include BlackRock Throgmorton Trust (THRG) which charges a performance fee but has lower ongoing charges than stablemate BlackRock Smaller Companies Trust (BRSC), which does not charge a performance fee.
It’s also worth checking out if a performance fee is capped and how much it is actually charged – some fees can be 20% outperformance, or even more. With investment trusts, this can also be a useful incentive if the manager receives the performance fee in the form of shares of the trust.
Simon Moore, founder of consultancy firm Trust Research, argues that trusts that buy illiquid assets could use the successful sale of stakes as a measure to set their performance fees.
Another benefit of just charging an ongoing fee, rather than that and a performance fee, is the simplicity, because investors immediately know exactly how much they are paying. A performance fee, on the other hand, creates uncertainty about the amount that will ultimately be charged. However, some trusts have moved away from ongoing charges in favor of a performance-only fee model.
William Heathcoat-Amory, head of investment trust research at Kepler, notes that Ashoka India Equity Investment Trust (OUCH) behaved extremely well. Its investment manager does not charge any ongoing commission, but will take a 30% commission on the outperformance against the MSCI India Index over three-year periods. As of May 6, 2021, the Trust had generated a 43% total share price return since its launch in July 2018, outperforming the 26% total return in pounds of the MSCI India Index during this period. UK Equity Fund Focused on Value Aurora Investment Trust (ARR) also works on a performance-only commission model.
A downside of a performance-only fee structure is that it can prove to be unsustainable for the investment manager in times of difficulty or if his portfolio, in theory, takes a long time to materialize. Neil Woodford effectively used the ongoing charges of his flagship open-ended fund to fund the management of Woodford Patient Capital Trust (now called Schroder UK Public Private Trust (SUPP)), which was based on a performance fee. But this trust has also experienced various issues unrelated to its pricing structure.