With the surge in flows to cheap, index-tracking funds in recent years, discussions about whether actively managed strategies should introduce a performance charge are likely to be quite short.
However, there are strong arguments in favour of the unpopular charges for closed-ended strategies, according to Kepler Trust Intelligence’s William Heathcoat Amory.
Heathcoat Amory, who leads Kepler’s investment trust research team, said cutting fees will not protect investment trusts from people looking for low-cost passive strategies.
Instead, trusts should make use of the advantages they have over passive funds, such as gearing, the ability to buy less-liquid investments, concentrated portfolios and dividend smoothing.
The Kepler co-founding partner said performance fees set correctly can offer investors the best of both worlds: a low base fee and a performance fee that only rewards managers who add value.
“Far from being the Achilles heel of the investment trust sector, we believe performance fees could be the root of its continued success,” he said.
“In our view, with the future bifurcating between those who are resolutely active or passive, there is very little ground for managers to occupy in-between.
“Recognising this fact, performance fees help rather than hinder the decision for an investor undecided between an active and passive strategy.”
Source: Numis, Kepler Partners
Heathcoat Amory said a pure performance fee structure was unlikely to be successful as it adds pressure to managers worried about keeping the lights on.
“Talent needs nurturing and never more so within active fund management when – by definition – a manager sometimes needs to underperform in the short run in order to outperform in the long run,” he explained.
However, boards have been moving away from performance fees recently with 10 trusts abandoning the practice in 2018 alone.
While 126 investment trusts of a total 338 strategies carry a performance fee, just 68 paid a performance fee in the last financial year totalling £473m.
“Whilst seemingly a very large number, this was earned off an asset base of £178bn, representing 0.26 per cent of assets under management,” he said.
Heathcoat Amory said performance fees are more often used in sectors where markets are less efficient and have higher potential for managers to add alpha or where they are more specialist or capacity-constrained mandates such as direct property, asset-backed lending and infrastructure.
One example of a mainstream equity offering charging a performance fee is FE Alpha Manager Alexander Darwall’s Jupiter European Opportunities trust.
“Two years ago, the board publicly stated that it had reviewed the performance fee, and – rightly in our view – retained it,” said Heathcoat Amory.
“It turns out that the board has been proved entirely correct in retaining it, for last week Jupiter announced that Darwall would be handing over responsibilities for his open-ended funds, but would remain manager of Jupiter European Opportunities.
“As such, the trust is the only way for non-institutional investors to retain access to Darwall’s management skills.”
The analyst said Darwall “has proved himself an exceptional manager who deserves an exceptional fee” particularly given the long-term performance of the trust relative to the peer group and its sister open-ended fund.
Yet, for the Kepler analyst there are two simple tests for whether performance fees work.
The first test, he said, looks at four trust sectors with relatively similar mandates and a representative sample of trusts with and those that have never had performance fees.
Source: Kepler Partners
“Performance fees have the desired effect – base management fees are considerably lower than they would otherwise be, reducing costs by between five basis points and 30 basis points on average,” said Heathcoat Amory. “Investors who are prepared to pay performance fees are benefitting from lower basic management fees.”
A second test is to compare trusts individually. The best ‘test case’ he said was the UK smaller companies sector where almost all the trust have the same benchmark and similar approaches.
There are seven trusts with performance fees, six without, and three that have removed them. The last grouping could cloud its results as they will have been ‘motivated’ to outperform for some of the time but not since they were abandoned, said the Kepler analyst.
The second test revealed – for the UK smaller companies sector – that for anything but the shortest time frames those trusts with performance fees have done markedly better than those that do not. This also held true for the European equity sector (with European smaller companies trusts rolled in).
Source: Numis, Kepler Partners
However, the completely opposite effect was seen within the UK All Companies and Global sectors. Heathcoat Amory said this may be due to the fact that there is a greater range of strategies in these sectors than the narrower UK smaller companies and European sectors making comparisons more problematic.
While the results were inconclusive, the analyst said that trust boards should allow their managers to embrace their mandates and become truly active, arguing for more performance fees not fewer.
“We believe that investment trusts can position themselves as the last redoubt for active managers, where other structures continue to buckle under the ruthless competition of low-cost trackers,” he said.
“Investment trust boards should arm their managers for the fight. They should encourage managers to demonstrate their ‘active’ nature by allowing them a flexible mandate, taking a long-term view on performance and giving them all the tools that the structure allows.”
He concluded: “They should counter fee pressures by offering managers the ability to walk-the-walk, and align them to successful active management. This is what performance fees are all about.”