PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN

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1 PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN Thomson Reuters All rights reserved.

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3 PERFORMANCE INCENTIVE FEE FUNDS POST DOWNTURN SEPTEMBER 2012 Four years ago, Lipper conducted a study of US funds performance incentive fees. 1 The data in the study went through December 31, In this paper, we will re-examine performance incentive fee funds to determine how they fared during the economic downturn in comparison to funds without performance incentive fees. Building on the findings from the original paper, we hypothesize that performance incentive fee funds will perform worse than their non-performance incentive fee counterparts during the downturn, but better during the recovery. KEY POINTS: The top five complexes with performance incentive fee funds comprise 96% of assets of all performance incentive fee funds. The most common index used as a benchmark is the S&P 500 index. Performance incentive fee funds have lower excess returns in the quarters where performance during the downturn is included. Since then, the findings are mixed. While performance incentive fee funds have higher performance in some quarters this is not consistent across all quarters. Performance incentive fee funds seem to take on higher risk than their counterparts without incentive fees; however, these risks have not paid off when the economic downturn is taken into account, on average. Boards may want to consider if the performance incentive fee fund is taking on too much risk to beat the benchmark. AUTHORED BY: SASHA FRANGER FIDUCIARY RESEARCH ANALYST FIDUCIARY SERVICES, LIPPER sasha.franger@thomsonreuters.com 1 Jonathan Kreider Paying for Performance. Please note that the views expressed in this document are intended as non-consultative and do not constitute legal advice. 1

4 INTRODUCTION US-domiciled funds have been using performance incentive fees for decades. 2 Performance incentive fees are designed to give investors a break from management fees when a fund underperforms its benchmark and to reward management when a fund outperforms its benchmark. Theoretically, this helps align fund management and shareholders interests; however, interests are already aligned because managers earn a percentage of assets. A graphical representation of the structure of a performance incentive fee can be seen in Figure 1. 3 This figure shows that a performance incentive fee is adjusted up or down depending on the percentage of outperformance or underperformance of the fund relative to its benchmark. It also shows that the incentive fee is equally applied on the positive end and on the negative end, and that the fee is in addition to the base fee. While performance incentive fee calculations vary across complexes and funds, the method employed by Putnam is an example of the trend in the industry. The following paragraph is the description Putnam provides for the performance incentive fee of their Growth Opportunities Fund: Each month, the performance adjustment is calculated by multiplying the performance adjustment rate and the fund s average net assets over the performance period and the result is divided by twelve. The resulting dollar amount is added to, or subtracted from the base fee for that month. The performance adjustment rate is equal to 0.03 multiplied by the difference between the fund s annualized performance (measured by the fund s class A shares) and the annualized performance of the Russell 1000 Growth Index, each measured over the performance period. The maximum annualized performance adjustment rates are +/ 0.12%. The monthly base fee is determined based on the fund s average net assets for the month, while the performance adjustment is determined based on the fund s average net assets over the performance period of up to thirty-six months. This means it is possible that, if the fund underperforms significantly over the performance period, and the fund s assets have declined significantly over that period, the negative performance adjustment may exceed the base fee. In this event, Putnam Management would make a payment to the fund. 4 FIGURE 1 GRAPHICAL REPRESENTATION OF A PERFORMANCE INCENTIVE FEE -6% -5% -4% -3% -2% -1% 1% 2% 3% 4% 5% 6% % % % % % % 0.021% 0.043% 0.064% 0.086% 0.107% 0.129% BASE FEE The structure of performance incentives allows for equal adjustment on the positive and negative side. Note: The top set of numbers corresponds to a percentage of a hypothetical fund s over/underperformance relative to a specified benchmark. The bottom set of numbers represents a hypothetical fund s base fee plus a performance incentive adjustment. 2 This is in stark contrast to European funds. Ed Moisson Performance Fees: Paying your Dues? 3 This is a reproduction of a figure in the paper by Jonathan Kreider Putnam Growth Opportunities Annual Report. 2

5 As of December 31, 2007, three percent of all funds representing six percent of industry assets were funds with performance incentive fees. As of July 31, 2012, the percentages have not changed: three percent of funds representing six percent of industry assets were funds with performance incentive fees. 5 Since 2007, some complexes have added performance incentive fees, and some complexes have removed performance incentive fees, and the complexes in the top five complexes has changed. Table 1 compares the top five complexes with performance incentive fees from the previous paper to data as of July 31, The top five complexes with performance incentive fees still comprise over 90% of all performance incentive fee assets and over 65% of all funds with performance incentive fees; however, the complexes have changed around a bit. RiverSource is no longer in the top five complexes due to a merger with Columbia and a subsequent removal of many incentive fees. This allowed Janus and USAA to move up the list. In 2009, Puntam introduced six new funds with performance incentive fees. In the same year, they added performance incentive fees to 12 existing funds while simultaneously lowering their management fees. This earned them a spot on the list of the top five complexes with performance incentive fees. In their Guide to Performance Incentive Fees Putnam states, The management fees adjust based on fund performance, which aligns the interest of fund management and shareholders, as an explanation as for why the incentive fees were added. TABLE 1 TOP 5 COMPLEXES WITH INCENTIVE FEES 2007 NAME NUMBER OF PORTFOLIOS NUMBER OF FUNDS TOTAL NET ASSETS 12/31/2007 ($ MIL) Fidelity ,310.6 Vanguard ,786.2 RiverSource ,683.3 USAA ,570.5 Janus ,940.1 Top 5 Total ,290.7 Industry Total , NAME NUMBER OF PORTFOLIOS NUMBER OF FUNDS TOTAL NET ASSETS 7/31/2012 ($ MIL) Fidelity ,005.2 Vanguard ,131.1 Janus ,000.0 USAA ,613.2 Putnam ,134.7 Top 5 Total ,884.2 Industry Total ,246.1 The top five complexes still comprise almost all of the funds with performance incentive fees. 5 The universe consists of all open-end funds. 3

6 Table 2 aandfigures 2, 3, and 4 provide more details on the kinds of performance incentives that are given to management. A total of 177 funds base their performance incentive fees against the S&P 500, Russell 1000 Growth, or the MSCI EAFE indexes, making these top three benchmarks used by performance incentive fee funds. By far the most common way to compare performance is by cumulative periods (91%), and the most common length of period is 36 months (65%). Figure 4 displays the dispersion of the amount of incentive fees. The median performance adjustment is 15 basis points (bps). TABLE 2 TOP 3 BENCHMARKS TOP 3 INDEXES NUMBER OF FUNDS S&P Russell 1000 Growth Index 49 MSCI EAFE Index 29 FIGURE 2 TYPE OF PERIOD FIGURE 3 LENGTH OF PERIOD Rolling Cumulative 3-month 12-month 36-month 60-month A majority of performance incentive fees are based on cumulative timeperiods. A majority of performance inventive fees are contingent upon a 36-month time period. 4

7 The previous Lipper paper on performance incentive fee funds found on average, over the past ten years, incentive fee funds have outperformed their Lipper classification averages. However, typically they have taken on a slightly greater amount of risk (as measured by volatility of returns) in doing so. This paper will determine if this remained the case throughout the economic downturn and ensuing recovery, or if a new pattern has emerged. The US economy started its downswing in late 2007 due to pressure from the subprime crisis. The economy bottomed out in the fourth quarter of 2008 and the first quarter of 2009, and has been on a vacillating incline since then. Based on the previous findings, Lipper expects that performance incentive fee funds underperformed funds without performance incentive fees during the downturn because of the greater risk they take on. However, we expect performance incentive fee funds to outperform in the years after the downturn. FIGURE 4 MAXIMUM PERFORMANCE INCENTIVE FEES High 2.400% Low 0.019% Median 0.150% The median maximum performance incentive fee awarded is 0.150%. Note: Figure 4 displays the high, low, and median maximum performance incentive fees. The individual gray hashmarks in the chart represent the maximum performance incentive for each fund, and the blue line is the median. 5

8 PERFORMANCE COMPARISON Figures 5, 6, and 7 compare the performance of funds to performance incentive fees with that of funds without performance incentive fees. Only funds in the same classification as performance incentive fee funds were included in the analysis. The S&P 500 index is included for comparison purposes. Figure 5 displays the annualized performance of these funds. In each of the periods, funds with performance incentive fees slightly underperform funds without performance incentive fees. Figure 6 provides the opportunity to zoom in and see exactly which years funds with performance incentive fees outperform or underperform funds without performance incentive fees. An interesting finding emerges funds with performance incentive fees outperform funds without performance incentive fees in all years except 2012 and the years corresponding to the economic downturn (2008 and 2009). FIGURE 5 ANNUALIZED PERFORMANCE Performance Incentive Funds Median Classification Median S&P Years 3 Years 5 Years 10 Years Funds with performance incentive fees underperform in all four annualized periods. Note: Figure 5 displays annualized total return performance net of expenses ended July 31, Only funds in the same classifications as performance incentive fee funds are included in the classification median. FIGURE 6 ROLLING ANNUAL PERFORMANCE Performance Incentive Funds Median Classification Median S&P In rolling periods, funds with performance incentive fees perform better than funds without performance incentive fees except in 2012 and the years corresponding to the economic downturn. Note: Figure 6 displays annualized total return performance net of expenses ended July 31, Only funds in the same classifications as performance incentive fee funds are included in the classification median. 6

9 Figure 7 provides one final perspective for performance comparison. The line graph charts the excess return experienced by performance incentive fee funds since December 1999 for quarterly rolling one-year periods. The number of months when performance incentive fee funds outperform funds without performance incentive fees is evenly split. In 25 of the 50 quarters, funds with performance incentive fees outperform their classification average. The most deeply negative time for performance incentive fee funds was 2009, which would include fund performance during the height of the downturn. Since then, during the recovery, funds with performance incentives have performed similarly to funds without performance incentives with excess returns bouncing around the zero mark since June During the last two quarters of 2010 and the first two quarters of 2011 performance incentive fee funds performance was better on average than funds without incentive fees; however, they performed worse in the next three quarters. In the final quarter in this chart, performance incentive fee funds performed just slightly better (0.17%). Some of our expectations are borne by the data. Funds with performance incentive fees underperformed during the downturn. While there is some evidence that they are performing slightly better in more quarters postdownturn, there is not enough data at present to decisively conclude this. FIGURE AVERAGE EXCESS RETURN OF INCENTIVE FEE FUNDS Average Excess Return of Incentive Fee Funds Performance incentive fee funds fare worse in quarters that include the economic downturn Note: Figure 5 charts the average excess return experienced by performance incentive fee funds on a quarterly, rolling annual basis Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun

10 RISK One of the main findings in the 2008 paper was that funds with performance incentive fees take on more risk than funds without them. We wanted to reexamine this finding taking into account the economic downturn and recovery. Figures 8, 9, and 10 compare different measures of risk for funds with performance incentive fees and funds without performance incentive fees. If a classification has less than five funds, it was excluded from the analysis. Figure 8 compares the standard deviation of funds with and without performance incentive fees (the standard deviation measures how much volatility there is in returns). In all three periods, funds with performance incentive fees have a greater annualized standard deviation of monthly returns with the greatest difference occurring in the threeyear period. This is an indication that funds with performance incentive fees are more volatile, and hence, are taking on more risk than funds without performance incentive fees. In the 2008 paper, Jonathan Kreider found that in the three-year and fiveyear periods, funds with performance incentive fees had a higher Sharpe ratio, which led to the conclusion that performance incentive fee funds had a higher risk-adjusted return compared to classification averages. This is not the case with current data, most likely because of the economic downturn. The rolling performance data (Figure 6) showed that funds with performance incentive fees performed relatively lower than funds without performance incentive fees during the worst years of the downturn. The Sharpe ratio (Figure 9) is lower for performance incentive fee funds in all three time-periods. This means that, on average, during the downturn, a performance incentive fee funds risk-to-return trade-off was lower than funds without performance incentive fees. FIGURE 8 STANDARD DEVIATION OF MONTHLY RETURNS (ANNUALIZED) Incentive Fee Funds All Other Funds Funds with performance incentive fees have a higher average annualized standard deviation higher than funds without performance incentive fees in each of the periods examined Years 5 Years 10 Years Note: The chart displays average annualized standard deviations for three-, five-, and ten-year periods. Classifications with less than five performance incentive fee funds have been omitted. 8

11 A similar finding emerges in the comparison of performance incentive fee funds alpha to the alpha of funds without performance incentive fees. In all three time-periods, funds with performance incentive fees have lower alpha than funds without performance incentive fees. This indicates that their excess return is lower than funds without performance inventive fees. Again, this coincides with the years where funds with performance incentive fees underperformed. Taken together, the risk measures indicate two findings: Performance incentive fee funds are riskier than funds without performance incentive fees evidenced by their higher standard deviations, and when current years are included, this risk is not resulting in higher returns. FIGURE SHARPE RATIO Incentive Fee Funds All All Funds Other Funds Funds with performance incentive fees have a lower average Sharpe ratio than funds without performance incentive fees in each of the periods examined Years 5 Years 10 Years Note: The chart displays average Sharpe ratios for three-, five-, and ten-year periods. Classifications with less than five performance incentive fee funds have been omitted. FIGURE 10 ALPHA Incentive Fee Funds All Other Funds Funds with performance incentive fees have a lower average alpha Years 5 Years 10 Years Note: The chart displays average alpha for three-, five-, and ten-year periods. Alpha is measured against the appropriate Lipper index. Classifications with less than five performance incentive fee funds have been omitted. 9

12 BOARD CONSIDERATIONS When it comes to comparing peers, boards may want treat funds differently if they already have performance incentive fees or if many of their peers have performance incentive fees. In circumstances when a board is renewing a contract for a fund with a performance incentive fee, the board may want to consider whether the fund has to take on too much risk in order to outperform their benchmark. To make this evaluation, the board may want to identify which of their peers have performance incentive fees and which do not. From there they can examine risk profiles and return. Too much risk is something that would have to be determined by the board. From an expense standpoint, the board will most likely want to consider where the fund falls in comparison to peers when the full performance incentive is realized from both a negative standpoint and a positive standpoint. For boards that have peers with performance incentives fees, the board may want to identify those funds and recognize that they are taking on more risk and that their advisor fee is not set in stone. Funds with performance incentive fees can easily be identified in the Lipper books by consulting the Exhibit entitled Contractual Management Fee Rates and Fee Schedules. 10

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