At its ‘Ideas Exchange’ (IX) conference in Melbourne last month, Watson Wyatt Worldwide flagged an increase in the use of performance fees, but not just for managers – for consultants too.

While the idea of performance fees for consultants is not brand new, Watson Wyatt consultant Andrew Spence presented a history of asset consulting which explained the evolution of the ‘business philosophy’ behind it and the ‘consultants’ challenge’. Put crudely, that challenge is how to make more money to pay for the ever-increasing demands of researching an ever-increasingly complex investment world. The consulting firms which dominated the institutional landscape through the 1990s now all have their own multi-manager offerings – Mercer, Russell, Intech and JANA – (followed by van Eyk Research in the retail space) leaving Watson Wyatt, Frontier, Access Economics and newcomer S&P as the main “independents”. The multi-manager consultants argue that their research efforts are improved by the additional resources available to them. The “independents” argue that the possibility of conflicting interests – whether or not they ever cause problems – is too high a price to pay. So, would performance fees for consultants represent a good compromise? Spence admitted that there were some practical problems to overcome. Performance fees may encourage short-termism, have been largely confined to implementation rather than strategy and are difficult to define. Watson Wyatt has had a handful of clients choose a performance fee system in the past, but these have been based primarily on the value add through manager selection. The more important level of value add will usually come through strategy, from strategic asset allocation to the selection of various alpha-enhancing or risk-reducing strategies. These decisions are invariably taken after lengthy discussion by the trustees. And setting a performance fee for demonstrating a reduction in risk is particularly difficult. Similarly, Mercer has had several clients choose performance fees in the past, but has largely abandoned the practice because of various difficulties. One of the biggest problems is psychological. If the fund performs well, the trustees have to sign a big cheque. In Mercer’s case, each time a performance fee was used, the client ended up paying more. In one case, the client was so disappointed about its own decision that Mercer allowed it two years to pay the bill and then reverted to a retainer fee-based remuneration agreement. If the client is in a multi-manager fund, the fee is taken out automatically from the fund’s returns. Even though everyone knows the same amount of money is taken out, it does not seem to hurt as much as having to sign a cheque. The basic problem, though, is that consultants need to be paid more money. A traditional retainer-based asset consulting contract will cost a fund between $250,000 and $500,000 a year. While that may seem like a lot of money, the business people who have to run the consulting firms don’t think so. As Watson Wyatt’s Andrew Spence said: “Research and innovation require talented, experienced – an expensive – people.”

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