…should be good for the gander
We’ve written extensively on alignment of interests between fund managers and their clients previously. It’s a cornerstone of the Allan Gray Australia business. But what exactly does this mean, and how can we achieve this?
One way is through charging a performance fee for our funds. This means we have to generate outperformance to earn a performance fee, but in turn our clients benefit through higher returns on their investments. Put simply, a performance fee means that we do better when our clients do better, and vice versa.
How do our performance fees work?
All of our funds charge fees in the same way – with base fees that are lower than the average active manager (or in some cases zero base fees) and a performance fee that applies only when a fund’s performance exceeds the current high-water mark. The base fee enables our company to ‘keep the lights on’, but we can only generate meaningful profits when our performance fee is charged.
What is the high-water mark and how does it benefit investors?
The high-water mark is crucial in ensuring the performance fees charged are fair. The high-water mark is the highest level of outperformance that a fund has achieved versus its benchmark, after accounting for any base fees. Each time the fund reaches a new high, the high-water mark is reset. The reason the high-water mark is so crucial is that it protects investors from paying fees twice.
For example, if one of our funds exceeds its high-water mark the performance fee kicks in. If our outperformance continues, the performance fee continues to be paid. But if we undergo a period of underperformance, investors stop paying the performance fee. If we then start to outperform again, we can’t charge a performance fee until we reach the previous level of outperformance. This means investors can enjoy a period of outperformance, without paying for it.
Graph 1 helps explain this concept. It shows the hypothetical relative performance of a fund and the points in time when the high-water mark is reached (as shown by the grey horizontal lines). The concept of relative performance is important here. The line is not showing the total performance of the fund, but rather the amount by which it is outperforming (or underperforming) its benchmark over time. When the line moves upward, the fund is outperforming. When it moves downward, it is underperforming.
Graph 1 | Example of how the high-water mark works
Source: Allan Gray
The fund can only charge a performance fee when its relative performance is above the high-water mark (the grey line). As you can see, the fund has outperformed the benchmark significantly over time, but has only been able to charge a performance fee when the high-water mark has been exceeded.
This is one of the fairest ways to charge a performance fee and shows true alignment of interest between the fund manager and its clients.
As you can see in Graph 1, those who invest when the fund is below its previous high-water mark are rewarded with outperformance without incurring a performance fee until the high-water mark is surpassed. Investors are therefore benefitting from this outperformance but only paying the fund’s base management fee.
The structure of our performance fees means that our business will only truly prosper if we do well for our clients. We must outperform if we want to earn higher fees, and that outperformance benefits our clients. It’s a win/win situation.
