MARCUS Rautenbach, head of investment consulting at Simeka Consultants & Actuaries, said paying for performance is a good idea in principle but it is open to abuse.
Benchmarks represent a unit trust or collective investment fund's target performance and are usually indices (such as the JSE All Share index). Any returns above the benchmark, called alpha, are often used to calculate the manager's performance fee.
"Investment managers are encouraged to work harder at achieving the portfolio's investment objective and receive additional fees only when producing alpha," said Rautenbach. "In practice it often leads to the use of benchmarks that are not sufficiently challenging, which enable investment managers to achieve alpha and earn performance fees."
There are regulations aimed at making sure that investment funds are used only in the best interest of investors or policyholders. Is this practice legal?
"Not only is it legal, it happens frequently," said Rautenbach. "On the institutional side of business there are no regulations that I've seen. I've tried, without success, to find guidelines for collective investment schemes. I strongly suspect that no clear regulations exist in this environment either.
"For collective investment schemes total expense ratios include performance fees. A performance fee on poor performance (very low benchmark) may hamper future commercial aspects of a unit trust fund. The best interest of a policyholder is often a vague concept."
Rautenbach said high-risk funds with an aggressive investment mandate often charged higher performance fees. Traditional funds with a balanced basket of assets over the long term charged performance fees usually capped at predetermined levels. "In theory, performance fees are commensurate with the level of skill required or shown by managers."
While a particular benchmark format was not preferred over another, a good one should be objective, appropriate, robust, unambiguous, and specified in advance.
Many large asset managers use the performance of their peers as a benchmark. Allan Gray uses the mean performance of managers surveyed by its consulting actuaries to measure the performance of its global balanced portfolio.
Rautenbach said peer benchmarks, used by as much as 60% of the dominant fund managers in SA, were perhaps more difficult to achieve but were only measurable after the fact.
"If everybody in the peer group performs poorly it's okay for the manager being measured to earn a performance fee on slightly better, but still poor, performance."
Kenny Rabson, deputy CEO of Discovery Invest and Discovery Life, said they did not charge performance fees on any of their unit trust funds.
"Performance-based fees are a widely accepted industry practice that we believe could in instances lead to investors paying fees that cannot be justified.
"Certain funds, however, do build complex mechanisms into their performance-based fee structures to prevent unfair fees from being charged," he said.
Investors should examine monthly fact sheets issued by investment managers before choosing to invest in a particular fund.
William Fraser, a portfolio manager at Foord Asset Management, said: "Benchmarks should be fair and reflect the clients' objectives. Managers' remuneration should be linked to achieving the set objective, [which] should be agreed on between the manager and the client, and their consultants.
"If the client is invested with a manager via a segregated portfolio, then he has the choice.
"If he is invested in a pooled portfolio he doesn't."