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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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