HAPFS’s Ho questions merits of performance-only fees

May 7, 2018

Performance-only fees do not necessarily better align investor and manager interests, says Doris Ho, executive director of Hong Kong's Hospital Authority Provident Fund Scheme.

HAPFS’s Ho questions merits of performance-only fees

Paying investment managers just performance-related fees is an enticing idea, but its implementation does not always result in the intended alignment of interests between investors and fund managers.

That's the warning from one of Hong Kong's largest public sector pension funds.

“The way you structure performance fees might affect the performance behaviour of fund managers because their income is based on such performance,” Doris Ho, executive director of Hong Kong's Hospital Authority Provident Fund Scheme, told AsianInvestor in an interview last month. “You need to decide on process by which you assess performance because there are multiple ways of doing that and each one affects manager behaviour in a different way.”

Performance-only fees hit the spotlight this year after the world’s largest pension fund, Japan’s $1.4 trillion Government Pension Investment Fund (GPIF), introduced a new fee structure in April that pays active asset managers a fee based on the excess returns generated over and above the agreed benchmark, but slashed annual management fees.

The upshot of that for active fund managers is that if they fail to generate excess returns, then their fees would be comparable to those of passive fund managers.

Investment industry opinion is mixed over the extent to which other asset owners will follow GPIF’s lead.

Advocates of performance fees say they help to better align the interests of investors with those of asset managers in three key ways: by discouraging asset gathering; reducing aggregate industry fees because only managers that outperform get paid additional fees; and motivating managers to generate higher returns.

But while great in theory, performance-only fee structures are tricky in practice, HAPFS’s Ho said. For example, what is the best time period for assessing investment performance and how might that choice affect the risk tolerance of fund managers?

"Over a 12-month period, for instance, if a manager underperforms in the first 11 months, he or she might be behaviourally tempted to make up for the 11-month underperformance by taking much riskier bets,” she said.

If the bet is right, he or she can make up all those earlier losses, but if the bet is wrong, there could be much bigger losses, Ho added. “I don’t really want my fund managers to take excessive-risk bets at an inappropriate time because in the end, we are long-term investors and seek the most efficient risk-adjusted returns.”

EXPENSE RATIOS

Another challenge highlighted by Ho is that of keeping down expense ratios—the annual fees charged by funds to investors.

Typically, a performance-only fee structure requires sharing 10% or 15% of the profits generated by a fund manager.

"If we have to pay 10% or 15% as a performance fee on a 10% [above-benchmark] performance, that would be equivalent to 1% to 1.5% of the portfolio value, which is quite high and our members won’t be happy,” Ho said.

It could also lead to more variability in expense ratios: in a year when funds don’t perform well, the expense ratio will likely fall, but in a good-performance year the expense ratio could shoot up, she pointed out.

Currently, the expense ratio for HAPFS is around 50 basis points (all inclusive), Ho said.

Ho acknowledged that it’s disappointing to pay managers when they don’t perform as expected or underperform.

Currently, HAPFS pays most of its external managers a base fee, which is paid irrespective of whether they perform well or not. Some managers are paid a performance fee as well, in which case the base fee would be a little lower than for those managers with similar mandates who are paid only base fees, she said.

GROWING APPEAL

Ho added that introducing a fee structure by which assets managers don't get paid if they underperform but face a fee cap if they do outperform was unlikely to sit well with asset managers.

She was not referring to any particular institution. The new fee structure of GPIF, Asia's most famous advocate of the model, is not thought to include a maximum rate.

What's clear, nonetheless, is that with active fund managers facing rising performance and cost pressures as interest in passive investment vehicles boom is that the debate over performance-only fees looks set to continue heating up.

In October last year, global fund manager Fidelity said it would overhaul its fund fee structure, linking it at least in part to how well a fund performs.

Closer to home, Singapore-based Aggregate Asset Management is another advocate of the performance-only fee principle: starting with just S$3 million ($2.2 million) in 2012, the fund house has since garnered about S$500 million ($374 million) in assets under management.

“Based on our current growth trajectory, we expect our AUM to grow to between S$1.5 billion and S$2 billion in five years,” Kevin Tok, executive director of the fund house, told AsianInvestor.

The fund house follows a zero management fee model, making money from performance fees only. “When clients make absolute profits, we earn 20% of the net profit,” Tok said.