KEY POINTS:
Two weeks ago we reviewed a report by British accounting firm Grant Thornton on fund manager performance fee arrangements.
Performance fees for local managed funds are a pretty mixed bag, with funds with a heavy institutional shareholder base generally being reasonable and those with retail shareholders typically more generous.
In reality many deals work like a free option on the stockmarket for fund managers, paid for by unit-holders.
That unit-holders can potentially get shafted by a sharp fund manager with a new performance fee proposal really does highlight, for listed funds, the importance of having an independent, intelligent and proactive board of directors.
In contrast, unit-holders in an open-ended fund like a unit trust have to rely on their trustees who are sometimes seen to be asleep or, worse still, in the orbit of the fund manager.
Property For Industry (PFI), which has done well for shareholders and whose board is well respected, has a pretty fair performance fee in that the manager of the fund (AMP) gets 10 per cent of shareholder wealth created over 10 per cent a year.
Importantly the fee is capped at 1.5 per cent and the PFI base management fee is a very reasonable 0.35 per cent a year on assets over $175 million.
PFI manager Ross Blackmore says performance fees can't be viewed in isolation. They have to be assessed in the context of the base management fee.
The implicit trade-off in a performance fee is that the base management fee will be less than it would have been had there been no performance fee. That isn't always the case, however.
Brook Asset Management, whose unit trusts have performed well for unit-holders and whose directors help keep our stockmarket honest with their "in your face" relationship with some local companies, has an infrastructure and property fund with a particularly generous performance fee arrangement.
The infrastructure fund's fee is uncapped and is 15 per cent of the amount by which the fund's performance exceeds the 10-year government bond yield plus 2.5 per cent.
So far so good - until you realise that 10-year government bonds yield just 6 per cent. Brook is in the money once its fund returns more than 8.7 per cent.
The really bad news for investors is that many of the funds in the Australasian infrastructure space have cash dividend yields of more than 10 per cent.
For example, the four biggest stocks in the Brook Infrastructure portfolio today yield 10.1 per cent, 9.6 per cent, 11.3 per cent and 13.3 per cent, respectively.
On the basis of these dividends alone, before any capital growth - before any management, even - Brook will get a performance fee.
In its defence, Brook says it "has imposed a high-water mark on the calculation of the performance fee and will not begin charging it until the unit price of the fund is above all previous year's closing prices.
"This means that the recent weakness in the prices of infrastructure securities [which has led to the attractive yields] will not result in a performance fee until after prices have recovered"; and the fund "has a low base management fee of 0.75 per cent and the overall management expense ratio before performance fees is capped at 1 per cent. We believe that level of base fees is low relative to other retail funds in the market."
The directors of the listed Kingfish Fund (KFL) regularly agonise over the extent of the company's discount but maybe part of the reason for the disparity between price and NAV (net asset value) is the attractive performance fee arrangement enjoyed by Carmel Fisher and her crew.
Fisher Funds (the Kingfish Fund management company) has had more than $7 million in performance fees since KFL listed in 2004. Not bad from a fund which started off with only about $50 million in assets.
For this money you might expect shareholders in the fund to have enjoyed high returns. Yet the share price of KFL today languishes just a few cents higher than its issue price three years ago.
KFL's assets/share has risen from 95c to about $1.32 but even this doesn't compare well with the market. In the same period the NZ Stock Exchange's Midcap Index Fund has returned about 58 per cent and the computer that makes the buy/sell decisions for this passive index fund doesn't get a performance fee.
One of the recommendations of the Grant Thornton report is that full details and a worked example of the performance fee calculation should be in every annual report.
Many local companies publish full details once when they start up and that's it.
The combination of an absolute return benchmark for a share fund like in KFL's case means that in some years when the stockmarket does extra well a very large performance fee can be payable even though performance over a longer term may be less than that of a more relevant benchmark index like, in KFL's case, the NZX's midcap index.
The GT report says: "Performance fees need to be devised so that they pay managers for their value added and do not simply reward them for the strength of the market."
It is far more common overseas among long only equity funds to have a benchmark which accurately reflects the company's investment mandate and risk profile.
For KFL this means mid-sized New Zealand companies, not risk-free 90-day bill returns plus a margin.
The GT report also recommends performance fees be capped (KFL's isn't) and fund managers take some of their performance fees in shares (Fisher Funds does this and at NAV rather than based on price).
In the March 31, 2007 year when KFL shareholders paid Fisher Funds $4.5 million in performance fees, KFL returned in NAV terms 36.8 per cent. In the same period the NZX Midcap Index returned 27 per cent.
KFL comfortably outperformed the relevant benchmark that year so a performance fee was in order. But if standard practice in Britain is any guide, the benchmark should have been the NZX Midcap Index, which would mean less outperformance and lower fees.
Carmel Fisher points out that KFL has a high watermark and the KFL NAV needs to increase by 27 per cent to reach the high watermark so KFL shareholders pay only the management fee for the next 27 per cent of performance.
Secondly, the fee structure for Kingfish features both "carrot and stick" in that while above-benchmark performance is rewarded with a performance fee, below-benchmark performance is penalised with a reduced annual management fee.
Thirdly, "we have long argued that a market index benchmark is not appropriate given the skewed nature of New Zealand's sharemarket indices and also given our investors' preference for absolute returns. Our investors will not thank us, nor want us rewarded for a negative return, even if we have outperformed the benchmark index."
* Disclosure: Brent Sheather may own shares in the companies discussed above.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
