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.
So what ’s the alternative?
We think the primary goal of any alternative proposal needs to be based on alignment of interest. The client provides the capital for investments, and the manager makes income by investing this money. The client is the one taking the bulk of the risk, not the manager. Skilful managers should be paid appropriately for what they do. Skilful managers can make a positive difference to a client’s return although the bulk of any portfolio’s return and risk will be dictated by its asset allocation. However, aiming to add even 0.5 per cent after all costs, taxes and fees to a total portfolio from manager selection is a valuable long-term goal, especially if absolute returns from markets are lower. Our alternative proposal is to combine a flat-dollar fee, adjusted annually by some measure of wage/cost inflation with a performance-based fee. The flat fee would cover the basic costs of running the business, not including performance-based remuneration for staff or excessive base salaries. The performance-based fee would be the primary source of profit for the firm. The fee model might vary by manager and by asset class and so implementation will not necessarily be standardised. It is important to encourage people with skills to establish funds management businesses and so fee structures should not act as a disincentive to new firms. Investors and fund managers will need to develop tailored fee agreements that adequately remunerate those who start new businesses but also reflect the fact that it is the investor taking most of the risk in handing over money to be managed. Further, it will be critical not to incentivise the wrong risk-taking behaviour just to try to earn a performance based fee. But it is no longer acceptable to argue against the principle of pay for performance and an improvement in the alignment of clients’ interests with those of funds managers. The period over which performance fees are paid is important. Most of Frontier’s clients are long-term investors and it makes little sense to pay out performance fees based solely on one-year returns. Pay-outs based on both shorter (one year) and longer term returns (at least three and preferably five years or longer) make much more sense and send two messages to managers: (1) that clients are truly interested in being long-term investors (this would also send a message to the market and companies about their ability to invest in their businesses for the long term), and (2) that clients are prepared to be patient while high quality managers execute their investment strategies. This latter point is critical – investor focus on short-termism creates pressures on fund managers to worry about shortterm returns too. They then place pressure on companies to perform over the same period. Do successful companies execute their strategies in a quarter? Or even a year? The reality is that they rarely do, and pressure on them to do so leads to a weaker long-term outcome for the company. Sum that up across the market and the impact on the economy is clear. Unlisted investments pose specific challenges in relation to fees. Many investors invest via pooled funds as the assets are large and lumpy. More problematically from a fee-structuring perspective, liquidity is typically low and the fund lives are long. Investing in unlisted asset classes introduces issues such as fees on commitments versus invested capital, buy/sell fees, transaction fees, advisory fees, investment period fees versus mature on-going management fees, work fees, other fees (e.g. director fees), claw-backs, hurdles, vesting, fees on realised versus unrealised performance and so on. Again, these are hurdles that need to be overcome but it seems to us that improving on the status quo would have a positive impact on investors’ returns and is therefore an appropriate target at which to aim. Readers should note that this does not necessarily lead to lower fees. In fact, lowering fees is not the overriding intent of this exercise. Rather, we are much more concerned about using fee structures to motivate fund managers to perform better for clients.
So what now?
Frontier expects that the superannuation industry will comprise fewer, larger funds over time and this presents challenges for the funds management community, which, to this point at least, has seen considerable proliferation of funds managers offering funds management services. There will be increased competition for clients’ investments, and managers who offer innovative solutions on alignment of interest and fees are likely to be in stronger contention for these mandates going forward. This is a material change in the dynamics of the funds management industry and will have profound consequences for some funds managers. The changing nature of the industry presents an important opportunity for clients to take more control of how they align their interests with those of people who manage funds on their behalf, to consider how much they are prepared to pay for these services and how they can structure fees to maximise this alignment of interest. Frontier has proposed an alternative here but recognises that successful implementation will be critical. Most of the criticism about this proposed model so far surrounds the flat dollar fee. Our view is that it is the combination of the flat dollar fee with a performance based fee that will align interests and we are not suggesting just a flat dollar fee. That would be too radical! Managers with confidence in themselves and their processes ought to be more comfortable with this new fee arrangement as the performance component would enable firms to pay performance-based salaries to staff and to reinvest in their businesses. From a client’s perspective, a greater focus on performance-based fees may lead to higher fees being paid at a time when markets are weak and overall fund sizes have fallen. This will increase the overall management expense ratio at a time when members and sponsors are likely to be facing poor and even negative returns. This will need to be addressed by way of fee structures and pay-out periods, but also by ensuring that members and sponsors understand the nature of the fee structures employed and their long-term expected outcomes. Finally, it is worth noting that this discussion applies to the payment for prospective generation of additional returns in excess of the index, often called “alpha”. By far the greatest contribution to a total portfolio return is the performance of the combination of market-based asset classes or “betas”. Getting the asset allocation (i.e. the mix of betas) right over time will make a far greater difference to an investor’s end result than adding value from fund manager outperformance. Ironically, most super funds spend much, much more of their “fee budget” on getting alpha than getting beta. It would also be opportune for clients to review the totality of fees paid and determine whether they should be more appropriately allocated.
This article is featured in this month’s edition of Investment & Technology magazine.