An increased focus by investors on costs and fees is driving major changes in the funds management industry. AMP Capital’s Multi-Asset Group Head of Portfolio Management, Debbie Alliston, talks about how to determine whether paying for performance is warranted in this type of market.

“During the last three years, equity markets have generated strong returns and you were decently rewarded for holding a passive exposure through this period,” says Alliston.

“In fact, it was a difficult environment for concentrated equity strategies because company share prices were less driven by fundamentals.”

In the US alone, about US$3 trillion dollars moved from active funds into passive funds during the past decade, a study by research provider TABB Group showed. The outperformance of many low-fee passive funds over higher-fee active funds helped drive this shift.

This may not be the case for long, though, as governments start to unwind stimulus policies implemented post the financial crisis, according to Alliston.

“We’re moving towards a more normalised economic environment where stock prices will be less driven by broader macroeconomic concerns,” Alliston says.

“This is a more rewarding environment for stock pickers and therefore it is an environment where it may make sense to incentivise managers who have demonstrated skill to outperform the benchmark.”

Performance-based fees are paid to managers when a strategy outperforms a certain pre-agreed hurdle or benchmark.

“This is important,” says Alliston. “It ensures an alignment of interests.”

Performance-based fee arrangements are typically used by managers who run high-risk strategies relative to a benchmark index, private equity, hedge fund strategies and unlisted infrastructure. In many cases, these strategies are not accessible with a traditional fee-only arrangement.

Portfolio managers only get PBFs when out-performing

An example of this could be an equity manager that outperformed the ASX 300 by three percent (after investment management fees) over each of the past 3 years. If it had a 20% performance fee structure of any return above the index (after investment management fees), that fund would pay a performance fee of 0.6%, leaving the investor with a net fee return of ASX300 + 2.4%. If it underperformed the ASX300, no performance fee would be payable.

Performance-based fee structures are also typically structured using “high water marks” where managers must make up previous underperformance before receiving any future performance fee payment.

In what is expected to be a modest return environment going forward where share prices are driven more by company stock specifics, good stock pickers with performance-based fees may return to favour.  

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.