When paying for investment perfomance, use an appropriate benchmark

Performance fees, paid to asset managers when they outperform a predefined benchmark, are increasingly being used to reward superior asset manager performance instead of more traditional fixed fee structures that remunerate on the basis of a flat percentage of assets.

The challenge, says Meyer Coetzee, Head of Product Development at SYmmETRY Multi-manager, is how to calculate these performance fees. "They are meaningless if returns are judged according to inappropriate or flawed benchmarks, or if the structure of the fee scale or the measurement terms are not conducive to fair evaluation."

He suggests that investors look for five factors when establishing a benchmark for the purpose of setting performance fees. The benchmark should be appropriate, unambiguous, investable, measurable, and reflective of current investment conditions for proper measurement of the skill a manager employs in managing the portfolio. In South Africa's less evolved and, therefore, less efficient markets, these can be hard to find.

"For example, it's not uncommon to find a portfolio with a high level of exposure to equities being benchmarked against consumer inflation. Over the long term this might be appropriate as the risk of short-term market driven distortions are mitigated, or averaged out. Over the short-term, however, it is impossible to distinguish between manager skill and market impact."

Over the last year, the average equity unit trust returned 38%, while inflation was just 5.4%.

Says Coetzee: "The rationale behind performance fees is to reward asset managers for the value they add through skilful management. The intention is that they should align manager and investor interests by driving manager behaviour, improving industry capacity management, and by making products more affordable.

"The hope is that managers will take more active risk and, through skill, enhance returns while, from an affordability perspective, performance fees will align manager remuneration with client returns.

Coetzee adds that one of the main advantages of performance fees is that they allow skilful managers to earn the same level of fees on smaller pools of assets by generating superior returns. Their alternative would be to gather more and more assets, possibly at the cost of compromised performance.

He says the methodology adopted by SYmmETRY Multi-manager has been to develop appropriate benchmarks and performance fee scales that strive to ensure that performance fees are a function of true value added, rather than external factors.

'Given difficulties in creating proper benchmarks in our market and the inherent peer focus of investors, one solution might be to combine a performance fee scale that pays a portion of excess performance delivered in fees to the asset manager, while also considering the performance of other managers. Some form of peer ranking determines the portion of excess performance paid. This two-tier approach fuses the concepts of paying for competitive returns relative to an appropriate benchmark and other managers."