Balancing rewards for unit trust managers

The Association of Collective Investments (ACI) hosted a breakfast conference in Sandton on 10 May 2007. Guest speakers were invited to discuss fees in the unit trust industry. After a quick review of the recently introduced Total Expense Ratio (TER), the

At present, two fee structures are favoured locally. The first is the fixed fee, and the second it the performance fee. Each of these fees is levied on the total assets under management in a particular unit trust. It should be noted that even the performance fee structure contains a fixed fee element. A typical unit trust operating with a performance management fee structure includes a minimum and maximum percentage coupled with a benchmark to measure fund performance.

Why a fixed fee element has to remain

One of the conference attendees asked why, if asset managers were so confident in their abilities, a minimum fee was levied in a performance fee structure. It was noted that the primary function of a unit trust is to protect investor capital while providing a return to cover the cash eroding impact of inflation and taxation.

If asset managers were unable to charge some form of fee in negative years the unit trust funds would come under severe cash flow pressures. Administrative systems would falter and staff would leave in droves. The result would be that investors funds would come under significant risk.

This fixed fee provides some much needed security to an industry which plays a significant role in independent retirement planning in South Africa.

Strong arguments for rewarding performance

Paul Steward, Chief Operating Officer for Plexus Asset Management presented some of the pros and cons for both fixed and performance fees. In his view, the performance reward structure often resulted in lower fees than when fixed fees were levied. In addition, the use of performance fees prevented asset managers from simply operating as cash collectors, allowing them instead to limit inflows and concentrate on providing better operating results. Some of the best managers in the unit trust industry worked on a performance fee basis.

Investec Asset Management's, Johan Schreuder put the case for performance fees. He believes the three greatest reasons for such are that they encourage better performance, contribute to fund affordability and enable effective capacity management. He also demonstrated that performance based fees often cost investors less than the fixed fee method.

The major argument against performance fees remains the operational complexity. Calculating and paying these fees is extremely complex and can result in fee bias from the unit trust companies. Such fee structures also increase the difficulty in budgeting for operations in a given period.

Striving for greater transparency

The collective investment industry in South Africa continually strives for greater transparency where costs to consumers are concerned. The ACI prescribes certain industry standard for performance fees. While this is not a regulated standard it makes sense for industry players to tow the line.

The speakers at this ACI function posed a number of questions about the appropriateness of regulation where performance fees were concerned. One such question was whether management fees should be capped? Schreuder said that the argument against such a move is fairly simple. Historically, the practice of commission capping leads to a single cost structure across an industry. All industry players tend toward the maximum regulated rate over a period of time.

A second question was whether or not benchmarks should be regulated. An improper benchmark was possibly the easiest way in which performance could be manipulated by fund managers. It was noted that the benchmarks submitted with new fund applications were already strictly assessed. If benchmarks were viewed as unacceptable, the submissions were returned to the fund in question for re-evaluation.

Unit trusts in South Africa continue to perform strongly and provide fantastic returns for long-term investors. The local unit trust industry has maintained 30% per annum annual compound returns since its inception. The ACIs focus on transparency is welcomed and ensures that the industry remains attractive when compared with some of the alternatives offered by the life and pensions industries.

Editor's thoughts:
We have previously noted that purchases of unit trusts tend to focus on performance rather than costs. With the introduction of the Total Expense Ratio, investors can simply scan a list of percentages and determine which fund operates with the lowest cost. Management fees are included in the TER and make up a major percentage of the total. Do you think investors benefit more from fixed management fees or from performance based management fees? Send your comments to gareth@fanews.co.za.