The percentage-based MER should become a thing of the past, and performance fees should combine with a flat-dollar cost-recovery base fee if funds managers are to be motivated in a more sustainable way, writes Frontier Investment Consulting’s managing director, Fiona Trafford-Walker .
The costs of running investment portfolios are many. These include investment management fees, brokerage, administration, legal, tax and investment consulting costs. Other than tax, by far the largest are those paid to managers and brokers. Frontier has been giving lots of thought to the fees paid to managers, and how the structure of these fees leads to certain behaviours that may or may not be in clients’ best interests. Fees are an important mechanism to adjust and align behaviour in the funds management industry. Managers respond to financial incentives that affect the management of existing investments and the development of new ones. If they perceive there will be business to be gained by developing new products in specific areas, then many will be motivated by the prospect of additional fees to develop them. Fee structures are therefore critical in trying to encourage certain behaviours and discourage others. “Good” behaviour includes the development of a sustainable business that has the best opportunity to deliver returns for clients including appropriate staffing, support resources and scale. “Bad” behaviour includes any activity that risks degrading excess return opportunities such as inappropriate asset gathering, product proliferation, inappropriate resourcing (both too many and too few), business instability, an imbalance in stakeholder interests (particularly challenging for listed asset management businesses) and poorly structured remuneration, especially that which might encourage a skew towards risk taking that is unacceptably high or low. Typical fee structures are based on a percentage of assets under management, and therefore move in line broadly with the market (allowing for the various steps and scales that can exist). Some managers offer performance-based fees, commonly with a base fee that is meant to cover costs and is determined as a percentage of the assets under management, plus an additional fee that rewards the manager for returns in excess of some prescribed target.
So what ’s wrong with the current approach ?
Revenue based on funds under management means that fund managers get a free kick from the market when it goes up. This increase in fees occurs irrespective of the manager’s skill and is due to factors outside its control. Why should clients pay for this? • Revenue based on funds under management means that fund managers get a free kick in the guts from the market when it goes down. The link with the market works both ways – when markets go down, a manager’s revenue will go down too. The consequences of this were very clear during the global financial crisis, when many managers were forced to reduce costs (i.e. sack people) to bring them into line with reduced revenue to try to maintain profit targets. • Weaker markets mean lower revenue and therefore a lower ability to invest in the future of the business. Funds managers who rely on the markets to grow revenues and hence reinvest in their businesses will find it hard to do so if markets go sideways for a period. • Without performance-based fees, there is no specific financial reward* for managers who perform well. Fees that go up and down with funds under management simply incentivise a manager to try to get as much in funds under management as it can. This is a perfectly logical response but many studies show that too much in funds under management in some investment approaches reduces the manager’s ability to add value. So while scale is valuable for some areas such as passive management, active managers should be encouraged to manage a lower level of funds under management and maximise their chance of performing better. (*There is of course the “reward” to the manager that comes from the additional fees paid by investors allocating portfolios to those managers who have performed well and who gather business as a result.) • Fund managers sell hope, and hope is not a strategy. No active manager can guarantee what its future performance will be. All that a firm can tell an investor is that it will apply all its resources to the task. Picking the managers who will do well is also not an easy task – all investors and consulting firms have processes to try to discern the better firms, but it is hard to predict future performance. Well-selected combinations of active managers can add real value to a client’s return, but effort and discipline are needed to discern the wheat from the chaff. Unfortunately there are many examples of active managers delivering passive-like returns over long periods. Ideally a good manager research process will weed most of these out. With performance-based fees and properly structured base fees, such managers would not earn adequate income and would ultimately cease to exist.