Fund managers, along with the rest of the financial services industry, are being dragged into better aligning their business models with the objectives of their clients. This is hard work for the protagonists for change (mainly the institutional consultants) as well as the fund managers, whose livelihoods can seem threatened. Managers are under pressure for a variety of reasons, and just like market correlations, the reasons have coalesced at an unfortunate time. The zero-sum argument has certainly gained credence lately. It is widely held as axiomatic that a group of relative return fund managers must underperform their market benchmark after fees, but a change in sentiment amongst clients means that this knowledge is now being acted on. Where once clients charged themselves with choosing the best active manager, now they will be more likely to hold a market portfolio until a manager which can prove its claims of outperformance comes along.

Immediately this puts pressure on pricing and the weight of assets supporting the analyst hordes is already shrinking as many large institutions have parked large allocations in passive portfolios. Then there is the not unrelated, GFC-induced market shrinkage. This has been somewhat redressed of late but most equity houses will still be 20 per cent off their pre-GFC revenue base, even without losing any significant mandates. Simultaneously clients are asking managers to look at ways of aligning interest and probably paying less. One prominent suggestion in the Australian market is fixed fees, plus a performance based component. Looking first at the absolute level of fees, there is compelling evidence that paying too much in fees is just about the worst thing an investor can do, especially if the expectation of commensurate performance is somewhat faith-based.

This is well laid out in a recent FT article by John Kay, where he compares what Warren Buffet’s own portfolio would look like if he had managed it as a fund and charged hedge fund fees – the fund would be worth $5 billion as opposed to $62 billion, with “Buffet Investment Management” having kept the remaining $57 billion (assuming the fees were reinvested). There are two implications: the impact of high fees compounded yearin, year¬-out is dramatic over the long term, and the co-investment model forces a different outcome. Berkshire Hathaway’s performance is itself a product of the fact that there was no Buffet Investment Management with its inevitable focus on growing revenue. However, this does not really align interests, it merely deals with incumbency by improving on an entrenched but faulty model. This will not affect the absolute level of fees as, by a process of competitive iteration, the fixed fees will end up closely resembling the existing cost base of individual firms and by extension the whole industry. More assets pay for more resources, which makes for a better organisational chart and in turn better pricing power.

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