Consultants getting active on new ways to pay external managers

STUART_david-13.05.10-photoA funds management fee which starts from a low base but ratchets up or down annually according to performance since mandate inception has been floated by Mercer as an alternative fee model.

Much as fiduciaries complain about it, the fee based on a fixed percentage of assets under management has remained the standard model for investment mandates throughout the world.

Easy as it is to calculate and implement, the fixed percentage fee is castigated for encouraging funds managers to asset-gather, potentially at the expense of investing excellence. It also means a manager’s larger clients subsidise its smaller ones.

There are cases where the fixed percentage fee model has been tweaked, acknowledged Michael Block, the chief investment officer of FuturePlus, an internal  funds manager for New South Wales municipal pension plans, at the Fiduciary Investors’ Symposium in Sydney, Australia, this week.

Most commonly, a slightly lower percentage based fee is combined with a “performance fee”, generally 20 per cent of the outperformance of an agreed benchmark.

However, Block pointed out that this incentivised managers to “go for broke” and take risks they otherwise would not, to try and enlarge their performance fee income – particularly if the arrangement was asymmetrical and did not include clawback provisions.

Another tweak, most often seen in the US, is the tiering of the percentage fee, such that it gets progressively lower the more a particular manager runs for a client.

While this arrangement reduced cross-subsidisation, Block said its complexity added costs to the beneficiaries, and it did not really address the incentive for managers to asset-gather, as the fees charged were still far less than the real cost of taking on additional FUM.

Block’s radical proposal was for mandates to be structured around a three-to-seven year “lock-up”, with enough paid to the manager along the way for cost recovery, but the performance fee component held back until the expiry of the lock-up. It would then be paid (or not paid) according to the long-term performance achieved against the agreed benchmark.

Speaking after Block, Mercer Investment Consulting principal David Stuart (pictured) suggested a fee model with a similarly long-term orientation.

In Mercer’s proposal, the mandate’s performance since its inception would be key, getting around the short-termism encouraged by yearly re-sets on performance fee calculations.

The mandate would begin with a low percentage-based fee, essentially enough for cost-recovery, which would increase after one year if the agreed performance hurdle was met. There would be no separate performance fee.

After two years, if performance since inception remained above the agreed hurdle, the base fee would rise again, and so on. An agreed cap would ensure the base fee level could not rise indefinitely. The fee would not be lowered if the mandate began tracking below the long-term performance expectation, so as not to encourage excessive risk-taking by the manager.