Performance based fees - Uncovered

GIB negotiates a low base fee with Destiny’s active equity managers. The fee is expressed as a percentage of the assets allocated to them.

In addition to earning these base fees, the managers also earn performance based fees if they outperform a predefined benchmark. Performance based fees are therefore designed to reward an active manager’s skill in generating outperformance.

Like fixed fees, performance fees are paid as a percentage of the assets under management, with the percentage determined as a share of the outperformance generated. They are designed to align the interests of asset managers with members and are earned by the underlying asset managers in addition to the base fees earned. As these managers share in outperformance along with members by deducting a portion of the outperformance received in the portfolio, members will not see an explicit deduction from their assets regarding performance fees as the unit prices are calculated after the deduction of any performance fees earned.

Performance fees have always been a topical conversation amongst investors, regulators and industry bodies. In its retirement-reform papers, National Treasury specifically highlighted these fees as an area requiring attention. This is largely as a result of them being poorly designed in instances and too complex for members to understand (particularly individual investors). Disclosure has also been highlighted as a pitfall.

However, performance fees provide a good tool to align the interests of the manager and the member, if structured correctly.

GIB has sought to standardise the basis for asset manager remuneration. Performance-based fees are set at levels that reward asset managers for desired outperformance without encouraging undue risktaking. In determining a fair and equitable performance-based fee, we consider the mandate of each manager to devise a basis that is consistent with the desired investment return and expected risk. We structure our underlying investment-manager performance fees with a number of key elements to ensure fair treatment of all parties and alignment of interest.

Common definitions and terminology that apply to performance-fees and the principles that constitute best practice

1. Performance-fee benchmark

This is the performance benchmark against which performance is measured to determine whether the manager is entitled to earn a performance fee. The objectives of the specific mandate and the performance-fee benchmark should always align. The fees should be paid for manager skill, not luck, nor market “beta”, which is what the market has done with no manager intervention.

2. Hurdle

The amount by which a manager needs to beat the performance-fee benchmark before earning performance fees.

3. Participation rate or sharing rate

The percentage of the performance above the performance-fee hurdle that the manager shares in.

A 15% participation rate implies a manager earns (retains) 15% of all performance above the performance-fee hurdle.

4. Cap

The outperformance of the hurdle after which no further performance fees are paid.

Caps are instituted purely to limit fees to an acceptable level. Uncapped by definition can result in limitless fees paid presuming, of course , outperformance is limitless. In the retirement-fund industry where a combination of capital growth and preservation is often required, anargument can be made for capped fees to limit needless risk-taking in the pursuit of performance fees.

5. Measurement period

The period over which the manager’s performance is measured against the hurdle to determine if a performance fee is payable.

Investing and skill should be measured over extended periods (at least a year). There is no correlation between a manager’s skill and performance against the hurdle over the short term. Market cycles and investment time horizons are longer as the risk of the asset class in creases. Measurement periods should align with the investment time horizon (longer for equity / capital-growth strategies and shorter for capital-preservation strategies).

6. The high-watermark

High-water marks ensure a manager does not earn performance fees unless itis generating new outperformance above the highest previous watermark. This prevents members paying for performance more than once where managers go throughout and underperformance cycles.

7. Crystallisation periods and clawbacks

A crystallisation period is when any performance fees payable are physically paid to the underlying investment manager. A clawback is a mechanism which ensures that the performance fees paid to a manager are kept current. If managers outperform, a portion of assets is set aside for them. If they underperform, these fees that have been set aside (but not yet paid or “crystallised”) are “clawedback”. At the end of the crystallisation period, whatever performance fees earned are then paid to the manager.

How GIB sets its fee basis for Destiny’s underlying equity managers

It is important to set fee scales to ensure that they are fair and reasonable to both our members and asset managers. To this end, we have looked at international best practice and guidelines on what a reasonable fee rate is for active managers who produce long term outperformance for our members.

Our specialist equity performance fee rate is determined based on the following:

• The appropriate “share of outperformance” between the manager and the member. This is determined based on the total fee paid by the member (in bps) divided by the total alpha produced by the manager (in bps).

• The sharing rate for equity asset managers of up to 1/4 this considered fair and reasonable. Anything beyond that is considered expensive.

• In determining the adequate fee level, the combination between the flat fee and performance-related fee is considered to ensure reasonability.

Example: A manager that has a R100 million local equity mandate with a benchmark of the Capped Swix plus a hurdle of 1% a year delivers 2% of outperformance over the measurement period with a participation rate of 15%. In this instance, the manager would earn:

2% outperformance minus 1% hurdle x 15% participation rate x mandate size = R150 000

NB This leaves R850 000 of the out performance generated through the manager’s skill for the members.

Frequently asked questions

Q1: Why does Destiny not show each underlying manager’s performance fee?

To negotiate the best possible fee arrangements on behalf of our members, we enter into confidentiality agreements with the equity asset managers and are thus unable to disclose the individual underlying asset manager’s performance fees.

Q2: Can some of the underlying investment managers in a portfolio earn performance fees when the overall portfolio does not beat the benchmark?

Yes. It is possible that some managers outperform and earn performance fees whilst others underperform, causing the portfolio as a whole to underperform the benchmark. This is, however, no different from the scenario where a member appoints managers individually on a segregated or even pooled basis. Importantly, though, the converse is also true in that a portfolio may outperform the benchmark with some managers earning no performance fees.

Q3: Do all members pay the same performance fees?

Yes. As all performance fees are paid by the portfolio and reflected in the unit price and all members share proportionately in the payment of these fees.

Conclusion

Our underlying local equity manager performance-based fee methodology is based on the following important principles:

• Asset managers should charge a low base fee with the ability to earn a higher fee only when they outperform the benchmark.

• The amount of performance fee charged to the fund in any year is capped.

• Where possible, a notional high watermark principle applies where a manager needs to make up any under-performance before charging a performance fee again.

• A rolling period of 12 months considering that alpha is not linear.

• •Similar basis from all equity asset managers within each of the portfolios, but these can vary slightly from asset manager to asset manager.