Can investors get value for money with current active management fee structures?
BY Staff | October 1, 2019
Asset managers usually increase their profits by gathering more assets to manage, but doing so isn’t necessarily helping the institutional investors that work with them.
“The dominant business or compensation model in the investment management industry basically boils down to this equation: assets under management times a fee percentage,” said Dan Brocklebank, head of U.K. investments at Orbis Investments during a webinar hosted by the Canadian Pension and Benefits Institute, on Thursday.
Under that basic formula, there are three ways asset management firms increase their profits, he said. They work to keep existing clients, they launch multiple funds so they have options that will hopefully be attractive to any given client and they can increase their sales forces. All three strategies, said Brocklebank, lead to growth in the firm’s assets under management, which is not necessarily a good thing for clients, especially if they’re implementing an active strategy.
“The clients’ investment goals over a time have nothing to do with how big a manager is,” he said. “In fact, as anyone with experience in investing will admit, beyond a certain point size is actually the enemy of investment performance. Clients should hope their manager stays small and nimble.”
Active managers have a natural incentive to grow larger and become more diversified, he said. However clients would almost always prefer their managers to remain dynamic and focused. This leads to a fundamental conflict of interest, he argued.
Within this context, investors should ask themselves whether they believe traditional fee models are adequate and whether or not there are ways to better align the interests of investors and asset managers, he said.
Recently, Japan’s government pension fund indicated that it’s fed up with the usual model fees follow, he said. Essentially the fund expressed that it no longer wants to pay fees regardless of performance and that it intends to overhaul its fee structure for active managers. “Change is coming from the biggest client out there and I think this is a formidable player to have.”
But in looking to improve the relationship between managers and investors, there is no silver bullet, he said.
“I’m certainly not going to say that we have the perfect solution. . . . The existing fee structure that is most prevalent across the industry does have some advantages. Charging fees as a percentage of assets under management is basically simple and predictable for all parties. Doing anything else is inevitably more complicated.”
However, it’s clear that simplicity is not enough to appease many investors, as evidenced by the surge into passive strategies over the past decade. “But what does this mean in the fee debate? For clients, the availability of passive funds is a huge development, because it offers investors the opportunity to get the average market returns basically for free. The flip side of that is that the rise and the acceptance of these so-called Walmart funds is that it’s forcing active managers to have to justify the value for money they offer to clients.”
Value for money is a relatively new concept within the investment industry, which does seem somewhat counterintuitive, he said. “Measuring value for money, in its purest sense . . . is actually pretty easy. We think you can look at value for money by assessing what percentage of any outperformance a manager is taking in fees.”
In appearing more attractive to investors, managers certainly can and have reduced fees, he said. “But fee cuts don’t solve the underlying problem. . . . Even with fee cuts, the incentive remains to increase assets under management, rather than to maximize performance.”
A true alignment between investor and asset manager would mean that the manager only wins if the investor does, he said. The solution, he argued, has to include results-based pricing.
“What other industry gets away with this sort of changing? What restaurant gets to charge full price for a burnt steak or corked wine and expect to stay in business very long?”
Notably, unlike any other transaction, investors never know the real value they’re going to get from working with a given active manager, he said. “Only time can tell you what that will be. And once you recognize that prior to investing with an active manager, the range of value they could deliver is very wide, and potentially negative, the only way to structurally embed value for money is to tie fees to the results or the performance levels that the manager delivers in practice, over the long-term.”