In its negotiations, Towers Watson has made more headway with hedge fund managers, whose open-ended vehicles make it easier to change fee rules, whereas private equity fee structures are cemented when funds are closed for years at a time. This has resulted in lower base fees – or base fees that are cut down over time – and betteraligned performance hurdles, such as calculating performance fees over longer time periods. These structures have applied to traditional equity and bond managers as well as alternatives funds. “We’ve been doing quite a lot of work on showing what proportion of prospective alpha that (managers) produce is being paid in fees,” Baker says. “Sometimes it doesn’t make sense for managers to be taking a higher proportion of alpha than clients, who supply them with the capital.”

He says the idea of collective action from pension funds to extract better fee deals and longer term mandate structures, often mooted at industry conferences and in the media, is “worth having as an aim”, but making it happen isn’t simple. In addition to seeking better fee alignment, investors should also pursue ‘smart beta’ strategies – such as fundamental indexing, volatility trading and currency-carry trading – and run them alongside marketcapitalisation weighted index funds. It’s important to look at these newer beta exposures, Baker says, since their market-cap weighted forebears do not adequately recognise the importance of today’s emerging markets. Since Towers Watson believes good diversification involves allocating effectively among risk premiums and managers, Baker’s team also spends a lot of time assisting clients with portfolio construction.

To manage ‘left-tail’ risks, or market crashes, clients must assess opportunities among various risk premiums – such as equity, credit, illiquidity, insurance and skill – but also carefully diversify among managers, Baker says. He says traditional risk models incorrectly assume that markets generate a normal distribution of returns when assessing asset class weightings. “You tend to get fatter tails. Extreme events happen more often than you think.” All investors can really do – in the absence of continuously, and expensively, buying insurance – is to diversify well. Even though different strategies tend to become correlated in a crisis, a well-diversified portfolio will have less probability of becoming completely correlated and should recover more quickly than a portfolio invested primarily in equities and bonds, he says. “Diversification didn’t help as much as everybody hoped in (the financial crisis) because it was a stressed environment. But over three, five and 10-year periods you would hope that diversification would help out a lot more.”

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