‘Not quite 6%’ fees: How this structure protects investors

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HILTON TARRANT: The listing of two Allan Gray Orbis Global Feeder Funds as active ETFs [exchange-traded funds] on the JSE attracted a large amount of attention in mid-December, mostly due to the fee structure of the underlying funds. Ordinarily, bringing active exchange-traded funds to the market would not be that noteworthy.

As at the end of November, the Allan Gray Orbis Global Balanced Feeder Fund charged a total expense ratio over a one-year basis of 6.17%.

Factor in transaction costs, which include Vat, and this increases the total investment charge to 6.26%.

The bulk of these fees, in fact 5%, is in the form of performance fees by the end of November.

The fund, which invests solely in the Orbis SICAV Global Balanced Fund, managed by Orbis Investment Management, delivered a one-year return of 30.2% in US dollar terms.

And, due to recent rand strength, a return of 23.4% in rands. This compares to benchmark performance of just 11.7% in dollars and 5.9% in rands.

We welcome Radhesen Naidoo, the joint head of the institutional clients team and head of Orbis Client Servicing in South Africa, to this podcast. Radhesen, thanks so much for joining us.

Let’s get right into it. Orbis has quite a unique structure where a proportion of performance fees go into its fee reserve. Take us through how the fee structure works.

Read: A fund with 6% fees?

RADHESEN NAIDOO: Thanks, Hilton. Thanks for having me. Yes, you are right. It is a unique structure in how the fees have been designed. It’s been around for quite some time in Orbis’s history as well.

So I suppose that the key point really is that when you think about performance fees, they link effectively what clients pay to the value delivered over the long term.

In this case, and what is perhaps a bit unique, is that the performance component when Orbis does really well – as you’ve pointed out, it doesn’t get paid over to them immediately. It’ll only get paid out very slowly if strong returns persist and they continue to do well.

What that allows for is that, if we have a period of poorer performance, those performance fees can subsequently be refunded.

And so what it comes down to from our perspective is that it really incentivises long-term thinking and this then sort of discourages short-term risk-taking, I suppose, on behalf of our clients.

And it ensures that over the longer term that clients ultimately pay something that’s linked to the value added as an active manager. That’s in a nutshell what the structure is there to create.

HILTON TARRANT: So investors currently are seeing these elevated fees precisely because there’s been a sustained period of outperformance?

RADHESEN NAIDOO: So in this case what’s happened over the past – as you point out with the returns, it’s been an incredibly strong year – and so the fund has delivered in excess of 20% over its benchmark, and the fees responded to that, which means the performance fee component is at 5% over the last 12 months.

The important piece though is that actually that’s how it looks, I guess, on the fund fact sheet.

It hasn’t been paid over to Orbis yet, so the portion that has actually gone over to Orbis is only just over 1%. And so most of it just sits there in a reserve over this period or at the moment.

And so it’s reflective effectively of what’s happening.

It’s reflective of a very strong outperformance period over the last 12 months, which we shared in.

And that’s what’s effectively explaining the higher number, I suppose, on the fact sheet.

HILTON TARRANT: And of course it must be mentioned that that 23% performance is actually after fees.

RADHESEN NAIDOO: Yes, exactly. Effectively that return is already in excess of the benchmark after the fee as well.

So that’s an incredible result for the Orbis team – when you think about where stock markets have been – to generate that kind of outperformance.

It’s been quite impressive in a very testing kind of market to do that, really driven by stock-picking skill overall.

HILTON TARRANT: So Radhesen, if we were to kind of play this forward and say, for instance, we now have 24 – even 36 – months of underperformance, how does this refund mechanism that is quite unique to this structure protect investors?

RADHESEN NAIDOO: Sure. I think that’s probably a really important point when you think that for any investor right now they’re looking at this and asking themselves what happens going forward.

The first thing I’d say is that, well, if you had to see that fee level again over the next 12 months, it means Orbis has done a really good job again.

In the converse scenario, what happens if we do an average job or a below-average job? And that means actually those performance fees held can actually effectively revert back to the investor.

So in a really poor scenario, effectively, let’s say we were under by the benchmark by about, let’s say, 10% – in that kind of scenario, you get back about 2.5% of the performance fees.

So that’s essentially what it what would happen in that scenario.

And then the last thing I’d say is that from an investor behaviour perspective, because we know how clients look and respond to performance is quite emotional, during those periods of underperformance you find clients often are moving between funds and switching.

So hopefully you also have a structure that truly shares in that kind of pain over those periods and can help or assist, because we’re actually sharing in that quite directly over those periods as well. And how to [remain], I suppose, invested through the cycle to benefit from our investment approach.

So that would also be like a secondary point as to how it can help, I suppose, from an investor behaviour perspective.

HILTON TARRANT: You mentioned earlier that there’s a portion of these fees that haven’t been paid across to Orbis yet. They’re just sitting there in that fee reserve. What if that fee reserve runs out?

RADHESEN NAIDOO: Sure, it can run out in two scenarios.

The first scenario is underperformance, and in this case it would have to be quite a bit in order to empty it.

The other scenario is that Orbis will be earning a portion from that fee reserve. The way it works is simplistically that if from today onwards Orbis simply performed in line with the benchmark for the next three years, it [the fee reserve] would eventually run out, so they [investors] are effectively earning a third of it per year.

And then at that point, if the question that people might ask is what happens if it has run out [and] you continue to underperform, in that case, what we do is we set a high watermark.

So effectively we have to catch up anything that we’ve underperformed from that point onwards before we can charge a performance fee again.

So it’s completely symmetrical on both ends. You can’t earn a performance fee unless you’re actually above water.

HILTON TARRANT: Is this fee structure in place for all Orbis funds?

RADHESEN NAIDOO: It’s available for a lot of clients globally and across our institutional base as well.

Its history dates back to the early 2000s effectively, as a structure, and globally as well across the various regions that Orbis operates in – be it in the UK, the US, for example. So yes, it is it is well used across all the Orbis suite of funds and in different regions.

HILTON TARRANT: Can we talk more broadly about fees? How is Allan Gray – and by extension Orbis, as a partner – responding to what can I guess [could] charitably be described as downward pressure on fees in the market, especially when it comes to things like performance fees?

RADHESEN NAIDOO: Sure. It’s a fair point, and I think what ultimately matters is the way in which we’ve always thought about fees – ensuring that they are purely reflective of value that we’ve added over the longer term.

I think you’re always going to have a downward pressure in markets; that’s a global trend. And our fee rates have kind of come off because we’ve adjusted our fee structures over time.

I think the more important point for us is that we’ve been a performance-fee house for a very long time, and a real benefit of that, from our perspective, is creating a strong alignment incentive, which we think is pretty important when you think about the active-management game that we’re in.

As an investor, when you’re in a fund and you’re picking a manager, the outcomes are uncertain. And when you are looking ahead, I think if you really want your active manager to deliver outcome, you need a structure that aligns to that.

That’s why, from our perspective, performance fees have worked well in that regard – and particularly if they are well designed and aligned.

So we’re always monitoring that and making adjustments. But I think the big piece is there is this question around, well, the performance fee structure as a whole – and it’s something we’re quite passionate about and something we’ve believed in quite strongly over our history.

HILTON TARRANT: Now these two active ETFs were listed on the JSE in mid-December. Let’s start off with what is an active ETF and what is the investment case specifically for these active ETFs in the South African market?

RADHESEN NAIDOO: That is great.

I suppose it’s a new route for investors to access our investment expertise, particularly actively managed portfolios.

The simplest way I can describe it is that you’ve got the same unit trust investments available, the Allan Gray Orbis Global Equity and Global Balanced Feeder funds, which have been around since the mid-2000s. Essentially those are unlisted. You invest in them via Allan Gray on the platform or directly with us. So these would be listed versions of them, effectively, that can now be traded on the JSE. But are ultimately governed by the same structure.

They are governed by Cisco, which is the same sort of regulatory framework on how the underlying product works and it allows investors to now effectively trade in these underlying trust vehicles, but trade on them via the JSE.

And it’s supposed to expand the pool of investors that could access these products in a relatively low-friction way as well. The framework didn’t exist until a few years ago, so that has been a new route that many managers have launched products on – what we’ve now done over the last few months as well.

HILTON TARRANT: Radhesen Naidoo is with Allan Gray. He is the joint head of the Institutional Clients Team and head of Orbis Client Servicing in South Africa. Radhesen, thank you so much for your time.

RADHESEN NAIDOO: Thanks, Hilton. All the best.

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