With asset managers exploring the potentially precedent-setting move of charging performance fees in active ETFs, it is time to unpack what would make such products tick.
ETF Stream reported service provider Goldman Sachs ETF Accelerator noting performance fees had been “very topical” in conversations with clients, while white-label issuer HANetf is in discussions with some clients looking to implement them in an ETF.
Ossiam, which operates a range of passive and active ETFs, is monitoring the potential use of performance fees.
But with opaque shareholder registers and prices that can diverge from NAVs, implementing performance fees in ETFs is easier said than done.
It bears considering what rules are in place, which performance fee models are possible within ETFs and whether there will be demand for such structures.
What has been allowed so far?
While no ETFs charging performance fees have yet received approval in Europe, a handful of exchange-traded products (ETPs) – not regulated under UCITS and therefore subject to lower regulatory scrutiny – have been green-lighted by the authorities.
The Short Volatility Long Tech ETP (SVLT), for instance, a Leverage Shares product which offers long exposure to the Nasdaq 100 index and short exposure to VIX futures, charges a performance fee of 10% subject to a high-water mark (HWM).
The 10% performance fee is crystalised daily, in other words paid to the manager, when both the NAV of the ETP exceeds the previous highest NAV – so the fund is above its HWM – and performance on that particular day is positive.
SVLT effectively charges performance fees over and above an absolute benchmark of 0%, which could be rationalised by the fact it does not explicitly look to outperform an index.
Kronos Strategy ETP (KRON), however, another Leverage Shares product, charges a performance fee of 20% over and above an absolute benchmark of 0%, which appears at odds with its aim “to outperform the S&P 500 over a market cycle.”
ESMA guidelines
Performance fees may be charged in UCITS vehicles provided they comply with European Securities and Markets Authority (ESMA) guidelines.
In essence, the performance fee model must be consistent with the fund’s investment objectives, align with investors’ interests and constitute a reasonable incentive for the manager.
The fee model employed by KRON would almost certainly be rejected on these grounds.
The ESMA guidelines provide for various performance fee models:
A Benchmark model – where performance fees are charged on the basis of outperforming the reference benchmark.
A High-Water mark (HWM) model – where performance fees are charged on the basis of the NAV per share exceeding its previous high during the performance reference period.
A High-on-high (HoH) model – where performance fees are charged if the NAV exceeds the NAV at which the performance fee was last crystalised.
A fulcrum fee model – where fees increase or decrease proportionately with the investment performance of the fund in relation to a benchmark.
The HWM and HoH models, as stated in the guidelines, are more appropriate for funds with an absolute return objective. No such UCITS ETFs with this objective exist.
As a result, “active ETFs must calculate performance fees relative to a benchmark index,” according to Jean-Paul Frisot, director at Deloitte Luxembourg, leaving the benchmark and fulcrum fee models as the only options for issuers.
The benchmark model
“Performance fees must be calculated at the same frequency as the NAV, so daily in the case of ETFs,” said Sergey Dolomanov, partner at William Fry.
If the ETF were to outperform its benchmark by 2% on a given day, the manager will be due a performance fee of 2% multiplied by the performance fee rate – itself no more than 20% according to the Central Bank of Ireland’s (CBI) UCITS Q&A.
However, because the fund may not keep outperforming, the guidelines prevent managers from crystalising the fees more than once per year, so they accrue in the NAV until either the annual crystalisation date or the investor redeems, whichever comes first.
The performance fee model employed by SVLT, where performance fees crystalise daily, would not be acceptable under the guidelines.
The benchmark model has been used in numerous active mutual funds. It is popular with managers because they benefit from outperformance and do not suffer from underperformance, unlike the fulcrum fee model.
The model works better for mutual fund investors because they enter the fund at specific dealing points with a specific NAV, so the outperformance versus a benchmark can be measured from their own entry point.
But ETF investors do not have this luxury, meaning the outperformance versus a benchmark would have to be measured at fund level, either since the inception or on a rolling investment period of at least five years.
This means an ETF investor could be charged performance fees despite personally experiencing underperformance. This would occur if the fund has outperformed its benchmark over the measurement period, but only thanks to strong outperformance before the investor entered the vehicle.
On the plus side, they would not pay performance fees on the outperformance they personally experienced if the fund’s underperformance took place largely before they purchased the ETF.
The fulcrum fee model
Perhaps the model most closely aligned with investor interests is the fulcrum fee model. There are some ETFs in the US using fulcrum fees, but the model has yet to be adopted in Europe.
An active ETF must have a ‘base’ management fee, but its total expense ratio (TER) will increase or decrease in a symmetrical fashion based on the performance of the ETF relative to its benchmark. Often the TER will be subject to a maximum and minimum.
If the ETF strongly outperforms its benchmark – measured over a multi-year rolling period – the TER could rise as high as 0.7%, the ‘maximum’ in this example, rewarding the manager for their good performance.
On the other hand, if the manager underperforms by the same magnitude, the TER will fall to 0.3%, effectively punishing the manager for their underperformance.
According to Dolomanov, “the performance fee, whether positive or negative, would be reflected in the management fee which is typically paid monthly.”
Fidelity International introduced the fee structure to a handful of its active mutual funds in 2018, citing greater alignment of “Fidelity’s interests to that of our clients.” But the model was scrapped three years later due to lack of demand.
Innovation down under
An ETF in Australia, the Macquarie Core Global Equity Active ETF (MQEG), has introduced an innovative performance fee model that combines elements of the benchmark and HWM models.
The HWM in this case, rather than a NAV per share – as defined in the ESMA guidelines – is instead a measure of cumulative outperformance versus the benchmark.
So if, prior to today, the ETF had cumulatively outperformed its benchmark by 8% since inception – the HWM – and thanks to great performance today that outperformance rises to 10%, a performance fee will accrue.
If, however, the ETF outperforms its benchmark today, but cumulative outperformance still sits below the 8% HWM, no performance fee will accrue.
No performance fee will accrue on days when the ETF underperforms its benchmark.
Macquarie charges a management fee of just 0.08% for the strategy, with a performance fee of 20% which accrues daily and is paid quarterly – this would have to be annually to comply with ESMA guidelines.
Compared to the benchmark model, this structure aligns closer with investor interests as it overcomes the issue of some investors paying performance fees despite personally experiencing underperformance.
Conclusion
While performance fees have worked in some settings – such as hedge funds and private equity – they may be viewed as an inferior way of aligning investors’ interests with those of the manager.
Although possible in ETFs, performance fees are difficult to implement and every model has its flaws.
Undoubtedly a handful of active ETFs charging performance fees will launch in Europe, but the structure could struggle to see broad adoption.
Fidelity’s failed fulcrum fee experiment should serve as a cautionary tale for issuers.
