The View

Will Fidelity’s ‘generous’ offer of performance-based fees be enough to attract investors away from index-linked funds?

Regulatory pressures are also behind the fund manager’s decision to only levy charges for funds outperforming their benchmarks instead of a flat fee

PUBLISHED : Wednesday, 25 October, 2017, 11:25am
UPDATED : Wednesday, 25 October, 2017, 10:51pm

Paying for performance has a nice ring to it – does it not? Fidelity, one of the world’s biggest fund managers, has decided that instead of charging a flat fee regardless of performance it will step up its competitive offering by only charging a management fee for funds outperforming their benchmarks.

However, Fidelity is a fund manager so this “generous” offer comes with caveats and small print, but we will deal with that later.

The whole question of fund managers’ fees is rising rapidly to the top of regulators’ agendas.

The European Union has already acted to enhance fee transparency and the regulator in the UK is considering even tougher rules. The reason for this activity is increasing awareness of costs to investors. The European regulatory authorities found that between 2013 and 2015 managed-fund investors lost 29 per cent of their returns as a result of fees, one-off charges and inflation.

No wonder managed-fund business investors are heading off in droves to index-linked funds, which have very low management fees and are performing way better than their rivals in the stock-picking business. Research from S&P Dow Jones shows nearly every company in the managed-funds arena failed to beat its benchmarks for the past decade.

The worm is slowly turning and managed funds are performing a lot better this year, but this improvement is doing little to move customers away from the tidal wave carrying index-linked funds.

Fidelity is looking for ways to stem the tide and is the biggest player to announce that it will both reduce annual management fees and introduce something called a variable management fee, dependent on fund performance. These changes will affect its globally sold products but not those offered by the US-based Fidelity Investments.

It is important to note that discretionary fees will be levied even where funds have lost money, as long as their benchmarks have lost even more.

Fidelity is not a pioneer in opting for performance payments from its customers as hedge fund managers have been operating on this basis for some time. They charge far higher fees than most mutual fund operators but only do so when they are returning healthy profits. Their customers pay little regard to these high fees as long as the total return is healthy. However, these investors are fickle and as hedge fund performance took a dive the rush for the exit was fast and brutal.

Fidelity operates in a bigger market and made the splashy announcement about cutting fees as, like other fund companies, it is trying to work out how to respond to new European regulations, known as Mifid II, which require fund managers to take the cost of research out of their management fees.

Other companies have indicated they will absorb this cost rather than pass it on to customers, but Fidelity is intent on doing the opposite and will be levying a research charge.

So, the closer you look at the Fidelity offer, the less shiny it appears. However, the underlying principle of rewarding performance remains and is important.

How will it work? In theory, fund managers will up their game under the pressure of increased financial incentives for better performance and the threat of lower income if they do not come up to the mark.

Incentives for better performance work in other areas of business, where a combination of stick and carrot has succeeded in producing pretty good results.

However, there are problems with the application of the performance theory in the fund-management industry because fund managers are increasingly making investment allocations that closely mirror the benchmark indices in the areas where they operate. In other words, their funds have become glorified shadow-tracker funds. If this is so, it will require a risky change of strategy to devise ways of beating these indices, with more likelihood of loss than gain. That, at any rate, has been the experience in recent years of managed funds trying to beat benchmarks.

Indeed, because more and more money is pouring into equities that make up the various indices, the task of focusing away from these stocks is becoming increasingly difficult.

It is hard to believe that Fidelity is unaware of this reality and its rivals in the managed-fund business must be anxiously watching to ascertain whether they too will have to change tack. These are desperate times for an industry that once coasted happily along on a sea of high fees paid by masses of customers who believed they had no alternative but to trust their money to these large institutions.

The exchange-traded funds revolution has shaken up this cosy state of affairs. As the fund-management industry thrashes around looking for solutions, things could get pretty messy.

Stephen Vines runs companies in the food sector and moonlights as a journalist and a broadcaster