Cherry Reynard investigates the role of performance fees in reducing the cost of investment company management.

The investment trust sector has traditionally prided itself on its low charges relative to OEICs and unit trusts. In a year when many investors are nursing large losses on their equity and bond portfolios, charges are subject to even greater scrutiny, so it is to the investment trust sector’s credit that charges fell in 2008 relative to 2007. But this masked a wide disparity in charges across different trusts and sectors. How can shareholders ensure that they are getting real value for money?

The Association of Investment Companies’ (AIC’s) latest total expense ratio (TER) figures (see table on page 77) show that the average annual cost of ‘managing’ an investment trust is currently 1.41 per cent, compared with 1.44 per cent in 2007. This is the fourth year of decline.

A range of costs
The lowest-charging trusts remain the large familiar names. The £94 million Independent Investment Trust is the lowest at 0.23 per cent, but it is rivalled by £436 million City of London trust at 0.37 per cent and the £724 million Edinburgh Investment Trust at 0.4 per cent. And the well-known global growth funds of Scottish Mortgage, (£1.11 billion), Alliance (£2.13 billion) and Foreign & Colonial (£1.64 billion) all come in at 0.52 per cent. The best value sectors are UK Income and Growth (average TER 0.8 per cent) and Global Growth (average TER 0.88 per cent), which are also the largest.

Nick Greenwood, chief investment officer of iimia, says the figures demonstrate an increasing polarisation in the investment trust sector. And much higher fees are seen in more complex areas such as forestry, infrastructure and hedge funds.

Greenwood adds, ‘The old traditional trusts such as Alliance Trust and Witan still have low fees. However, in recent years, particularly during the new issue boom of 2006/07, some trusts were launched with fees that looked more like those of the hedge fund industry – two per cent annual management charge plus a 20 per cent performance fee, for example. Either it was a bull market and they could get away with it or they were holding more esoteric investments.’

A question of performance
Recent years have seen a shift towards the increased use of performance fees, ostensibly to ensure greater alignment between the interests of shareholders and fund managers.

This proved crucial in bringing down costs this year. Including performance fees, the fall in TERs is even more marked, with the average TER including performance fees 1.56 per cent compared with 1.75 per cent a year ago. Fund management groups had often reduced management fees in order to justify introducing a performance fee. Many of these performance fees had a high watermark in order to ensure that fund management groups were not giving themselves hefty payouts while losing money for shareholders. Fewer performance fees were therefore paid in 2008.

In February 2009, 122 investment companies had a performance fee in place (51 per cent of total trusts) and 58 paid a fee. In November 2007, fewer companies had such a fee, just 103 trusts (49 per cent), but 70 actually paid out.

A fee worth paying?
Although performance fees have served them well this year, how can investors ensure that they are worth it in the longer term? Grant Thornton ran a survey last year that showed that funds without performance fees have historically beaten their benchmark more often than those with (53 per cent versus 59 per cent). At the time, the accountancy group said that shareholders should ensure that they put pressure on investment trust boards to ensure that the performance fee is structured properly to incentivise managers over the longer term, rather than simply paying out because of favourable short-term markets.

Greenwood believes in performance fees, incorporates them into his own investment trusts and likes to see them in trusts he is buying: ‘Performance fees work well to align interests. However, if a trust is bringing in a performance fee, it should bring down the basic fee. We dropped ours down to 0.5 per cent. There are some trusts that have only dropped it from 1.5 to 1.4 per cent, which is tokenism.’

James de Sausmarez, head of investment trusts at Henderson, says that the structures of the performance fees on the different trusts are ‘frighteningly diverse’ and that it is the responsibility of the individual trust board to negotiate an equable fee structure. He adds that investors need to look at whether fees are charged to net or gross assets. At the moment, gearing is relatively low on the majority of trusts, but if fees are charged to gross assets, investors will pay fees (both normal and performance fees) on the gearing as well.

Practising what you preach
So how do these fee structures work in practice? The performance fee put in place by F&C’s Investors Capital Trust was devised with existing and potential shareholders and represents a benchmark as to how these fees can work in the interests of shareholders.

Manager Roger McNair says ‘The company launched at £1 in 2007 and it receives a performance fee if it outperforms its benchmark, but not if markets are down. The performance fee is 0.9 per cent of net assets, but if the NAV drops below £1 it
falls to 0.75 per cent. The fee is paid at the end of five years.’

Witan’s multi-manager approach uses performance fees to incentivise managers on an individual basis. However, the move to multi-manager didn’t significantly affect the overall TER of the trust. Indeed, other factors have proved important in bringing fees down this year. The VAT ruling in 2007, which said that VAT had been unfairly charged on management fees, has helped lower costs, albeit only marginally. James Frost, the trust’s marketing director, says that Witan received around £800,000 from the VAT reclaim in 2008, and this was netted off against costs so helped reduce the overall fee for investors.

Counting the costs
Keeping an eye on management fees is particularly important at times of market volatility because bid/offer spreads tend to widen out. It is also more important in more complex, illiquid investments.

So how important is cost? Colin Eyre, chairman of the investment committee of the IFAlliance (a group of IFA firms that have developed their own Liberation range of multi-manager funds), says, ‘Some of our managers do include investment trusts in their portfolios. Investment trusts tend to have lower fees than unit trusts, which can help keep TERs down, but that isn’t necessarily the prime reason for including them.’

There can be little doubt that a good manager with low fees is better than one with high fees, but cost is only one aspect of return, even though its compounding effect can be significant. Performance remains key, as does dividend income and tax. Investors should take all these aspects into account when looking to invest.