Fund managers' costs are in the spotlight as industry experts endorse performance-based fees.
Percentage fees charged by fund managers can be a lazy way to riches - for fund managers that is, not investors.
The percentage fees charged by fund managers keep coming out of investors' capital regardless of the direction of markets. What's worse for investors is that it keeps coming out even if the fund manager loses more money during market downturns than the market itself.
According to a report from the Australian Institute of Superannuation Trustees, percentage fees end up rewarding fund managers for accumulating funds under management, not necessarily for producing good returns. The study, which mostly concerned Australian shares, recommended super funds move to a fixed dollar fee plus a performance fee when negotiating fees with active managers of share funds.
At the time of the release of the report in September, the institute's chief executive, Fiona Reynolds, said: "We need a fee model that does more than reward fund managers for managing an ever-expanding pool of assets, even when they have not contributed to that growth. In a compulsory system where you have legislated growth of 9 per cent, this is a licence to print money.
"If we are serious about reducing costs across the super sector, we can't ignore investment fees."
Investment markets rise and fall and fund managers cannot be held responsible for that. But the way they are paid has a big bearing on how well investors will do. Generally, investors will be better off with managers who are paid for performance, provided the performance fee is well structured.
Asset-based fees compound over time, just like interest on an investment. It's what the managing director of managed funds discount broker 2020 Directinvest, Michael Lannon, calls the "reverse miracle of compound fees".
Take fairly typical total fees of 2 per cent a year for a small investor and assume an investment return of 7 per cent a year. Lannon says that over five years, 7.3 per cent of the investment return will be paid in fees over 10 years it's 17.2 per cent and 31.5 per cent over 20 years.
TAX EFFICIENCY
The tax efficiency of fund managers is also receiving attention from superannuation fund trustees. Fund managers who "churn" their portfolio increase taxes for investors compared with those managers who buy and sell shares with less frequency.
The returns and fees of managed funds are mostly reported on a pre-tax basis rather than after-tax returns. Two managed funds with the same gross return could have very different after-tax returns - the returns that investors actually receive in their hands.
Last year, the health and community services industry fund, HESTA, required the Australian share-fund managers it hires to manage the money in a way that maximises after-tax returns. Simple steps can be taken by managers to increase the tax efficiency of their funds, such as making better use of franking credits, holding on to shares for longer to take advantage of discounted capital gains tax and decreasing the frequency of share trades.
HESTA expected the move would add tens of millions of dollars to the value of its Australian share portfolio by measuring and paying fund managers on their after-tax performance.
More managed funds have performance fees but they tend to be boutique managers who believe they can outperform the market. Performance fees are also found among managers investing in market sectors, such as small companies, where there is the potential for large "excess" returns over and above market returns.
Typically, funds that have a performance fee will also have a "base" fee - the usual asset-based fee. Usually, the performance fee will be a percentage of the returns above the market returns. Investors should be paying a base fee that is less than the base fee charged by funds without performance fees. A performance fee should not be triggered until a fund manager has recovered earlier losses.
Key Points
Asset-based fees eat into returns because of the compounding effect.
Asset-based fees can be "lazy" income for fund managers.
Performance fees may be better for investors.
Fund managers who "churn" their portfolios increase tax costs for their unit holders.
Frequently Asked Questions about this Article…
What are asset-based (percentage) fees and how do they impact my investment returns?
Asset-based or percentage fees are charges taken from the size of your investment regardless of performance. Because these fees compound over time—what the article calls the “reverse miracle of compound fees”—they can significantly erode returns. For example, the article shows that with a 2% total fee and a 7% annual return, fees would consume about 7.3% of returns over five years, 17.2% over ten years and 31.5% over twenty years.
Why are industry experts recommending performance-based fees instead of percentage fees?
Experts and the Australian Institute of Superannuation Trustees (AIST) argue percentage fees can reward managers for simply accumulating assets rather than delivering returns. Performance-based fees are recommended because they align manager pay with outcomes—so investors generally do better when managers are paid for performance, provided the performance fee is well structured.
What fee model did the AIST recommend for super funds negotiating with active share managers?
The AIST recommended moving to a fee model that combines a fixed dollar (or base) fee plus a performance fee for active managers of share funds. This approach aims to stop rewarding managers solely for growing assets under management and instead pay for actual performance.
How should a fair performance fee be structured for investors?
According to the article, a fair structure typically includes a lower base (asset-based) fee than funds without performance fees, and a performance fee that applies only to returns above market benchmarks. Importantly, the performance fee should not be triggered until the manager has recovered earlier losses—so investors don’t pay extra for short‑term or unrecovered underperformance.
What does “churning” mean and how does it affect my after-tax returns?
Churning refers to frequent buying and selling of stocks within a fund. Managers who churn increase transaction activity, which can raise tax bills for unit holders and reduce after-tax returns. Because most managed fund returns are reported pre-tax, two funds with the same gross return can deliver very different after-tax returns if one churns more.
How can fund managers improve tax efficiency to boost investor returns?
The article notes simple steps fund managers can take to increase tax efficiency: make better use of franking credits, hold shares longer to access discounted capital gains tax, and reduce the frequency of trades. HESTA required its Australian share managers to maximise after‑tax returns and expected this approach to add tens of millions of dollars in value to its portfolio.
Are performance fees common, and which managers typically charge them?
Performance fees are becoming more common but tend to be used by boutique managers and managers targeting sectors like small companies where there’s potential for large excess returns above the market. They’re less common among large mainstream funds but are found among managers who believe they can outperform.
What should everyday investors look for when comparing managed funds’ reported returns?
Investors should be aware that most managed fund returns are reported on a pre-tax basis. To compare funds accurately, look for information about after-tax returns and tax efficiency (including franking credit use and turnover/churn). Also review fee structures—base fees, any performance fees, and how performance fees are triggered—because fees and taxes materially affect real investor outcomes.
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