Can a performance-based fee improve mutual fund outcomes?

The market regulator had in December initiated a detailed study on existing policies pertaining to expense ratios 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 tied to performance. It is expected that the base fees would be reduced, and any additional fees would depend on the portfolio performing better than the benchmark. This would make India one of the few markets with such fees. Currently, 88% of actively managed funds, such as large-cap equity funds, underperformed the S&P BSE 100 in the year ended December. So, what remains to be seen is whether the new category can help improve the industry’s transparency and investor outcomes.

Scenario analysis

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

Standard/asymmetric performance fees—a popular fee structure—incentivizes fund managers for surpassing the benchmark’s performance 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, equal to the reward they receive for outperforming the benchmark. These types of fee align the interest of both parties.

This story takes a peek at what MF returns could look like with the new performance fees parameter. For this purpose, we have considered discrete gross returns of the funds over a period of three years in various scenarios. The first scenario shows returns under the current regime. We’ve taken TER to be 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) with the expense ratio going down with the increase in assets under management (AUM).

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

The third scenario shows returns after deducting a high TER/base fee and fulcrum fees. As mentioned earlier, fulcrum fees penalize the fund manager for failing to beat the benchmark hurdle rate. The TER is taken as 1.5% and a performance fee charged based on slabs rating a manager’s performance vis-a-vis the hurdle rate. The slabs are 0% for less than 1% of benchmark, +/- 0.10% for 1-2% of benchmark, +/- 0.20% for 2-4% of benchmark & +/-0.30% if the performance is greater than 4% of the benchmark.

As per Mint’s analysis, in case of a down year or underperformance, the total fee that an investor is charged comes down by a few basis points. One basis point is one hundredth of a percentage point.

But, should India should follow a symmetric or asymmetric fees structure? Sivanath Ramachandran, director, capital markets policy, CFA Institute, said, “On paper, the symmetric fees look better. However, the effectiveness of the fees would depend upon how the entire structure is designed. Also, note that comparing funds based on management and performance fee is more complex than just comparing management fees alone, so we need to balance the benefits of better incentives against concerns around transparency."

Prasanth Bisht, deputy CIO at True Beacon, had a similar view, “an asymmetric fee could lead to excessive risk taking by the fund manager. S,o to start with, symmetric fees can be introduced, and gradually other structures can be looked at."

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

The concerns

Fund managers may prioritise their own wealth over investors‘ interests by taking on excessive risk to maximize their expected fee return. This can lead to increased downside risk and drawdowns.

Fund managers who follow a benchmark have an incentive to secure profits by reducing risk when the fund return is greater than the benchmark. The opposite could also happen by increasing risk when the fund return lags the benchmark. In simpler terms, the fund manager may take action to make the fund’s value more volatile in the short term, or less volatile in the long term, in order to increase their compensation.

Fund managers can 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 interest of investors, as the managers can take on excessive risk or prioritize their own compensation over the investor’s returns.

An arbitrary period for fee crystallization can be misaligned with the investor’s holding period. For instance, what happens if the fund is up 50% on 31 March and charges a 20% performance fee and then the market plunges 20% the very next day? Will the fund manager forfeit the fee in such instances?

The benefits

There will be better alignment between investors and fund managers. However, better outcomes can be seen when the manager invests alongside clients in the same strategy. If a manager invests a substantial portion of his/her net worth in the same strategy as the investor, then the manager will be incentivized to perform better.

The fund house can increase its revenue based on the performance fees 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 the company’s revenues rather than the returns of investors.

Cross-comparison

While MFs are a retail product for the masses, portfolio management services (PMS) and alternative investment funds (AIF) offer more customized investment services to investors. The fee structure of both PMS and AIF is on a performance-fee basis. How does MFs compare with these two in terms of the new fee structure.

We compared the riskiest category—small-cap funds—in the MFs with the corresponding category in PMS. Over the past year, small-cap PMS has outperformed both small-cap MF and category III long-only equity AIFs. However, over a 5-year period, smallcap MF outperformed both of them by 200 and 300 basis points, respectively.

To be sure, category III long-only equity AIFs utilize leverage to maximize returns and offer portfolio opacity whereas PMSs offer a more concentrated portfolio leading to higher portfolio volatility as compared to MFs.

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 obtained from PMS Bazaar suggests that on a gross return basis, these AIFs have not outperformed small cap PMSs or small cap MFs. Additionally, long-only equity AIF funds have certain tax disadvantages compared to MFs, as they are taxed at the fund level and incur capital gains tax with each trade. AIFs also tend to have higher total fees than PMS.

With the introduction of performance fees, can we see AIF & PMS managers shift towards MFs? That, again, remains to be seen.

When asked about whether this could lead to outflows from CAT III Long Only Equity AIFs and PMSs towards these performance based MFs Ramachandran said, “Investors of Category III AIFs are not just driven by rational considerations like returns and fee structures, but also behavioural considerations such as the need for social status. As such, the impact of performance fees alone on flows is hard to predict".

Sandeep Jethwani, co-founder, Dezerv, feels that the introduction of performance fees is even better for the mutual fund investors who do not want leverage (AIFs can take leverage). He said, “ The difference in returns is not dramatic in case of equity PMS or AIFs. Post-tax, MFs already outperform PMSs & AIFs by a good 1.5-2%."

As for the final word on performance fees, remember what Warren Buffet said in a, 2017 letter to Berkshire Hathaway shareholders: “Performance comes, performance goes. Fees never falter." So, will performance fees be a blessing in disguise for investors? We are keeping our fingers crossed on this.