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A new funds manager fee model being promoted by Frontier Invest­ment Consulting, whereby managers are paid a fixed-dollar base fee plus a performance fee, has merit but must be carefully structured to avoid incentivis­ing managers to take excessive risk, stakeholders have warned.  Sean Henaghan, who runs AMP Capital Investors’ Future Directions multimanager funds, said investors have become less averse to performance fees as the fees become structured more fairly.  One manager gripe towards models dominated by performance fees is that they encourage punting, particularly after a couple of bad years when the prospect of earning a positive perfor­mance fee looks distressingly remote.

However Henaghan, who runs AMP Capital Investors’ Future Direc­tions multimanager funds, said the capping of performance fees on both the up and down sides can reduce the threat to managers’ business stability. Invesco chief executive Mick O’Brien said punting for most profes­sional investment managers would be “an anathema to the way they go about managing money”. “I don’t think it’s a risk that’s real,” he said. “You only offer these types of arrangements where you’re confident of your ability to generate alpha and from the clients’ perspective it’s an attractive arrangement because they only pay if they’ve got alpha generated and they pay a fairly minimal amount if no alpha’s generated.” Frontier Investment Consulting began talking to managers in June about adopting a new fee model which de-links funds manager revenue from assets under management.

 

The proposal would see managers have their esti­mated costs reimbursed on a fixed-dollar basis, and then earn their profits through a performance fee. Henaghan likes the concept of a flat cost-recovery fee, but said it would be a “nightmare” to implement. He pointed out that Generation Investment Management launched a global equity strategy with a flat $250,000 base fee plus a performance incentive – an idea they got from Watson Wyatt – but it “lasted about nine months before they started making excuses, and then they changed it to 42 basis points”. Given that Future Directions had been preparing to award Generation a $1 billion mandate, partly on the basis of the massive cost saving it would rep­resent over other products, Henaghan suspected the base fee had been a loss-leading strategy which the firm soon realised was too generous, especially when it was acting alone. Graeme Miller, head of investment consulting at Watson Wyatt, said in the current environment, managers might welcome the stability a fixed dollar fee brings to their businesses.

“Many managers have found themselves in highly stressed positions as a consequence of having all of their revenue linked to funds under manage­ment,” he said.  But he warned it would need to be well-designed to ensure managers’ inter­ests were aligned with their clients. “What you don’t want to end up with is a structure that incentives a manager to take excessive risk,” he said. AMP Capital’s Henaghan proposed that a manager who outperforms by, say, 20 per cent in a particular year only be paid immediately on the basis of 1 per cent – the 20 per cent remains in the managers’ ‘balance’ (preferably linked heavily to remuneration of the actual underlying portfolio managers) and can fluctuate up and down as underperfor­mance or overperformance is registered in subsequent years.  

 

On the downside, Henaghan proposed that managers who got too far ‘underwater’, but retained the confidence of their client, could have calculation of the performance fee reset. Howard Rosario, chief executive of Westscheme, said his fund welcomed the Frontier initiative. If mandates are clear from the outset, the risk of mis­alignment can be managed, he added.  “It’s about being very clear about the excess return expectations you’ve got, being very clear about what risk and tracking error you’re willing to toler­ate and also being as clear as you can be about the information ratio – the compensation for risk that you’re seek­ing,” he said. “If you put those in place and monitor them carefully I assume you’d be able to keep control or at least monitor that risk.” However Paul Ireland, head of implementing consulting at MLC, had never been keen on performance fees. “We only employ managers we expect to outperform over the long term, so if you negotiate a performance fee you’re giving away some of that outperfor­mance,” he said.

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