Imagine the following scenario. You’ve got a blocked toilet so you call the plumber, who comes and fixes your toilet and charges you an invoice.
Later, the plumber sends a second invoice for the same job. Confused, you call him and ask: “I’ve already paid you. Why are you sending me a second invoice?”
He replies: “Because I performed. I successfully fixed your toilet.”
“I’m sorry, I don’t understand,” you say. “Fixing the toilet was your job. That’s why I paid the first invoice.”
He replies: “Yes, but this second fee – the performance fee – ensures that I’m incentivised to do a really good job. If there are any leaks or problems, I don’t get my performance fee.”
This dialogue is absurd. But it’s not too dissimilar to what fund managers require Australians to believe every day.
Fund managers are unusual, so far as professionals go, in that they insist on being paid twice to do their jobs. The first time around, the management fee. The second time around, the performance fee.
The argument for performance fees is that managers need to be incentivised. Performance fees, which are only charged when managers do well, are offered as an effective way of doing this. And as they are only taken from the share of assets that outperform, there is no situation where charging a performance fee leaves investors worse off. Or so the argument goes.
But in an age of index investing its time Australians challenged this picture. And time they started asking fundamental questions about why fund managers should be entitled to them – even if they do outperform.
For starters, investors should ask what makes fund managers so different to the rest of us with jobs. And why do they need to be paid twice two work as hard as possible.
Doctors don’t tell patients: “I’ve done a good job writing your prescriptions: I’ve picked all the right pills. So I’m going to charge you a performance fee.”
But more fundamentally, investors should ask fund managers for evidence that performance fees lead to better outcomes. The burden of proof should lie squarely with fund managers.
A detailed study of pension funds in Europe recently found that “funds with performance fees have annual risk-adjusted returns of 0.50% below other funds”. And that funds deliberately pick benchmarks that were “easy to beat” so they could cream off fees.
In the US, where the topic has been studied heavily, a recent paper found that hedge fund investors received just 36 cents of every dollar earned by hedge funds thanks largely to performance fees. And extensive reviews by S&P Global have found that higher performance fees are more likely to lead to worse performance.
In Australia, the topic has received less research coverage. What research exists suggests the same is true here as elsewhere.
The solution: don’t invest in funds with performance fees
People tend to dislike idle criticism. Criticism is easy, finding solutions is hard.
But the solution to the performance fee problem is straightforward: investors should ask fund managers not to charge them. Failing that, they should invest in index funds or ETFs, as these types of fund charge no performance fees.
We’re decades into the active versus passive debate. And the longer the charade runs the more one-sided the evidence grows.
Fund managers don’t need to be paid twice two do their jobs – and no-one does. It’s time for the gravy train to stop.