Can Performance-Based Fees Improve Mutual Fund Results?

The market regulator had in December commissioned a detailed study on the existing policies relating to expense ratio of fund houses. Currently, the total expense ratio (TER), which includes management fee and other expenses, is charged from investors on a daily basis, irrespective of whether a scheme is performing well or not.

Now, media reports suggest that SEBI may allow a new MF category where managers’ fees are linked to performance. It is expected that the base fee will be reduced, and any additional fee will depend on the portfolio outperforming the benchmark. This would make India one of the few markets with such fees. Currently, 88% actively managed funds, such as large-cap equity funds, underperformed the S&P BSE 100 in the year ended December. Therefore, it remains to be seen whether the new category can help improve industry transparency and investor outcomes.

scenario analysis

Globally, mutual funds charge a fixed percentage as fee based on the net asset value of the investor’s investments. However, a large number of funds in the US and UK charge performance or incentive fees based on their returns relative to a benchmark.

Standard/Asymmetric Performance Fee – A popular fee structure – incentivizes fund managers to outperform the benchmark over a predetermined period. However, the fund manager is not penalized for poor performance. In contrast, Fulcrum/Symmetric Performance Fees penalize fund managers for underperforming, while rewarding them for outperforming the benchmark. These types of fees align the interest of both the parties.

This story takes a look at what MF returns could look like with the new performance fee parameter. For this purpose, we have considered the discrete gross returns of the funds over a period of three years under different scenarios. The first scenario shows the returns under the current regime. We have assumed TER at 1%, as is the case with most diversified equity mutual funds in India. Note that, in the current regime, funds can charge a maximum of 2.25% of TER (for regular plans), while the expense ratio is going down with the increase in assets under management (AUM).

The second one shows returns after deducting a standard performance fee of 20% from a lower base fee of 0.5% and a fixed hurdle rate of 10%. We have not considered any high water mark position for charging performance fee. For beginners, a hurdle rate is the minimum rate of return expected by an investor, while a high water mark (HWM) is the highest peak in an investment’s value. HWM ensures that a fund manager earns a performance fee only when the investment value exceeds its previous highest value.

The third scenario shows a higher TER/base fee and returns less the base fee. As mentioned earlier, Fulcrum fees penalize the fund manager for failing to exceed the benchmark hurdle rate. The TER is taken as 1.5% and a performance fee is levied based on the slab rating the performance of the manager vis-à-vis the hurdle rate. Slab 0% for less than 1% of benchmark, +/- 0.10% for 1-2% of benchmark, +/- 0.20% for 2-4% of benchmark and +/- 0.30% for over performance 4% of the benchmark.

According to PeppermintIn the analysis, in case of a year’s decline or poor performance, the total fee charged to an investor is reduced by a few basis points. A basis point is one hundredth of a percentage point.

But, should India follow a symmetric or asymmetric duty structure? Shivnath Ramachandran, director of capital markets policy at CFA Institute, said, “Symmetric fees look better on paper. However, the effectiveness of the fees will depend on how the entire structure is designed. Also, note that comparing funds based on management and performance fees is much more complex than simply comparing management fees, so we need to balance the benefits of better incentives against concerns around transparency.”

Prashant Bisht, Deputy CIO, True Beacon, had a similar view, “Asymmetric fee can lead to excessive risk taking by the fund manager. To start with S,O, symmetric fee can be introduced, and slowly- Slowly other structures can be seen.”

Furthermore, if the fee structure is complex with high water marks and variable hurdle rates, retail investors may find it difficult to make an informed decision.

concerns

Fund managers may prioritize their own money over the interests of investors by taking excessive risks in order to maximize their expected fee returns. This may increase downside risk and downside.

Fund managers who follow a benchmark have an incentive to secure profits by reducing risk if fund returns exceed the benchmark. The opposite can also happen as the risk increases when the fund’s returns lag behind the benchmark. In simple terms, the fund manager can take actions to increase his compensation to make the value of the fund more volatile in the short term or less volatile in the long term.

Fund managers may adjust the benchmark or hurdle rate after poor performance to make it easier for them to earn performance fees in the future. However, these changes may not be in the best interests of investors, as managers may take on excessive risk or prioritize their own compensation over investor returns.

The arbitrary period for fee crystallization may be misaligned with the investor’s holding period. For example, what if the fund is up 50% on March 31st and charges a 20% performance fee and then the market drops 20% the very next day? Will the fund manager lose the fee in such cases?

Benefit

There will be better coordination between investors and fund managers. However, better results can be seen when the manager invests in the same strategy with the clients. If a manager invests a substantial portion of his net worth in the same strategy as the investor, the manager will be incentivized to outperform.

The fund house can increase its revenue based on the performance fee and use it to attract and retain top talent. However, this can also create a potential conflict of interest, as the focus may shift towards maximizing company revenue rather than returns to investors.

cross comparison

While mutual funds are retail products for the public, portfolio management services (PMS) and alternative investment funds (AIFs) provide more customized investment services to investors. The fee structure of both PMS and AIF is on performance fee basis. How do mutual funds compare with the two in terms of the new fee structure?

We compared the riskiest category in mutual funds – small-cap funds – with the corresponding category in PMS. Over the last one year, small-cap PMS has outperformed both small-cap MFs and Category III long-only equity AIFs. However, over a 5-year period, Smallcap MF outperformed both by 200 and 300 basis points, respectively.

To be sure, Category III long-only equity AIFs use leverage to maximize returns and offer portfolio opacity, while PMSs offer more concentrated portfolios for higher portfolio volatility than mutual funds. .

However, it is important to note that past performance is not a guarantee of future returns, and investors should carefully consider their investment goals and risk tolerance before making any investment decisions.

Data from PMS market shows that on the basis of gross returns, these AIFs have not outperformed small cap PMS or small cap MFs. Additionally, long-only equity AIF funds have certain tax disadvantages as compared to MFs, as they are taxed at the fund level and capital gains tax with each trade. The overall fees of AIF are also higher as compared to PMS.

With the introduction of performance fee, can we see AIF and PMS managers moving towards mutual funds? That, again, remains to be seen.

When asked if this could lead to an outflow from Cat III long only equity AIFs and PMS to these performance based MFs, Ramachandran said, “Investors in Category III AIFs are driven not only by rational considerations like returns and fee structure , but also have practical considerations such as the need of the social situation. Thus, it is difficult to estimate the impact of performance fees alone on flows”.

Sandeep Jethwani, co-founder of Deserve, believes that the introduction of performance fee is even better for mutual fund investors who do not want leverage (AIFs can take leverage). “The difference in returns in case of equity PMS or AIF is not dramatic. After tax, mutual funds have already outperformed PMS and AIFs by 1.5-2%.”

As a final word on performance fees, remember what Warren Buffet said in a 2017 letter to Berkshire Hathaway’s shareholders: “Performance comes, performance goes. Fees never falter.” So will performance fees turn out to be a blessing in disguise for investors?