The 2009 cost of doing business survey by the Callan Investments Institute found that fees paid by US funds have been increasing on the back of higher allocations to more expensive asset classes and lower allocations to passive investment. Amanda White spoke with Callan’s executive vice president and director of capital market and alternatives research, Jay Kloepfer, about the appropriate asset allocation reactions to this phenomenon, and the value investors should expect for the fees they pay.
For US pension funds the cost of doing business has increased by 14 per cent in the past four years, from an average of 41.5 basis points of assets in 2004 to 47 basis points in 2008.
On average, external investment management fees represent nearly 88 per cent of the total fund expenses, which has focused pension funds attention on these fees, especially in the efficient sector of the market.
According to Callan’s executive vice president and director of capital market and alternatives research, Jay Kloepfer, this has culminated in some interesting ramifications in the past 18 months.
“In the past, funds wishing to save money on passive have engaged in securities lending. Now they are freaked out about that, they need to expect higher fees on the cheap part of the portfolio,” he says.
Overall the allocation to passive has decreased over the past four years, particularly for public pension funds, but Callan reports external management fees have increased across asset classes since 2004.
These higher investment costs are associated with increased average allocations to non-US equity, private equity and real estate over the same period.
But Kloepfer is not adverse to higher fees per se, and believes funds should also be cautious but not necessarily hostile.
“Personally I don’t have a problem with higher fees, it’s a way to ration access to high demand,” he says. “To assume someone is being taken advantage of is naive,” he says.
Instead, he says the best way to approach fees is understanding certain assets will be more expensive and to have some expectation of what you expect for those fees.
“Are you willing to absorb those higher fees and what are you getting for it?” he says. The differences in fees across asset classes is demonstrated in the 2008 average figures which show the median domestic equity fee was 38.4 basis points, while the median private equity fee was 146.9 basis points.
Kloepfer believes a lot of investors have had an irrational expectation of assets that attract higher fees, pointing to hedge funds in particular.
“We say you should expect returns between stocks and bonds with commensurate volatility, which is what they got last year. Those that were disappointed with 2008 had unreal expectations,” he says. “Cash plus a fixed amount is an unrealistic expectation as a benchmark [such as Libor plus 400 basis points]. There has to be a realisation there is the possibility of as much downside as there is upside.”
The Callan survey indicated one of the greatest cost-related concerns is whether the performance of their actively managed funds is keeping pace with the level of fees charged, and the new or increasing use of non-traditional investments driving up external management fees.
These are all relevant questions for pension fund executives to be asking, but Kloepfer believes there has been a rationalisation of expectations demonstrated by those which have hedge funds allocations, not moving away from them.
However he acknowledges that how funds measure value for money “is the $64,000 question”.
“The biggest question funds are asking right now is ‘have we built guaranteed inflationary problems’ into our portfolio, and how do we address that,” he says. “A year ago inflation in the US was 5 per cent. Now it is negative and the monetary and fiscal stimulus has been huge.”
He says funds are looking at allocations to inflation linked bonds, real assets, commodities, and real estate.
When considering inflation, Callan advises funds that have already allocated to real estate to use those allocations as a hedge.
“If you are focusing on short term inflationary spikes then maybe consider commodities in an equities portfolio,” he says. “Another option is also looking at building a real asset portfolio, a concentrated balanced portfolio, that will cushion/hedge the portfolio if inflation hits but that hopefully won’t have too much impact if it doesn’t.”
This “balanced portfolio approach” could see an allocation of 10 or 15 per cent, while an allocation to one strategy, such as commodities, would be more like 5 per cent.