OPINION

Not all fees are created equal

In discussing the fees paid by asset owners to investment managers, ‘alignment of interests’ is the objective most commonly stated.

But, in practice, almost all fees are structured either on the basis of a percentage of assets (such as 0.50 per cent), or a performance-related basis (with a base fee of for example 0.25 per cent of assets and a share of outperformance of say 20 per cent above a benchmark or target level).

But are there other ways in which fees could be structured which might, just possibly, be of benefit to both parties, which would surely represent an improvement in the alignment of interests?

Asset-based fees have obvious flaws.

They incentivise managers to grow their asset base by the greatest amount in order to maximise fee revenues (this is not a criticism of the behaviour of managers, it is just a logical view of the effect of these fee structures).

Growth in assets ultimately creates diseconomies of scale and the potential for reduced added value (‘alpha’) delivered by the manager.

Asset-based fees, particularly in volatile asset classes such as equities, also create volatility in levels of fee income for the manager and fees paid by the investor.

For some investors, this volatility can be a material issue, for example when fees are paid by a parent organisation or where fees have to be publicly reported.

For asset managers, it makes their business difficult to manage because their costs are predominantly fixed yet their income is highly variable for reasons outside their control or ability to forecast.

The problem could be addressed by having a fee structure which is a fixed monetary amount which could at outset be based on percentage of assets under management with agreed annual uplifts (for example based on inflation).

This would give both the asset owner and the asset manager a high degree of predictability as to the level of fees on a year-on-year basis, and, for the asset manager, there might be a willingness to accept a slightly lower level of fees than otherwise, because the predictability of this particular stream of income would give it additional value in terms of business planning, budgeting for expenditure and so on.

Performance-related fees are the conventional way in which alignment of the interests of asset owners and fund managers is meant to be achieved.  But as generally structured (base plus share of performance over benchmark) they are not without flaws.

First, to avoid the issue of asset growth leading to diseconomies of scale, performance fees should generally be combined with strict capacity limits for a strategy.

If the manager’s capacity is fully used up, then ‘success’ for the manager will solely be a function of performance through the mechanism of performance-related fees.

But what asset owners are happiest to pay for is not just ‘raw’ performance against benchmark, they want to pay for the added value created by manager skill.

And these are not necessarily the same: it is possible to generate outperformance of benchmarks by taking additional risk, such as by owning credit in a government bond-benchmarked mandate.  Leverage is another risk that can be used to enhance (or rather amplify) returns.

Managers can also adopt persistent ‘beta’ positions (i.e. overweights to an equity factor such as small cap) which may be more effectively captured via an explicit small cap mandate.

If one thinks about private equity mandates, these usually have a performance-related fee element in terms of ‘carry’ above a specified hurdle rate, say 8 per cent p.a.

At its simplest, returns from private equity can be thought of as having (potentially) three elements – a return from investing in equity-type assets, the leverage that is generally used in private equity investing, and the skill that managers use to create value in the businesses they buy and own for a period of time (we ignore for the purpose of this discussion other factors, such as value or size, that may also be driving returns in private equity).

This ‘idiosyncratic’ alpha, value creation by managers, is a really attractive source of return – it is probably fairly scarce and certainly diversifying relative to other sources of return.

Unfortunately, the ‘carry’ approach over a fixed hurdle rate is a very crude way of rewarding a manager for the skill they employ because the total level of return generated in a private equity fund will be heavily influenced by the performance of equity markets during the period of capital being invested ‘in the ground’, exacerbated by leverage, and skill applied will only be a third element on top of these two.

So 8 per cent p.a. will be too low a hurdle if equity markets are buoyant (managers who have demonstrated no skill will collect big performance fees) while it will be too high a hurdle in a period of weak equity markets and really skilful managers may not earn performance fees.

The way to address this is not simple, but it would be for the asset owner and fund manager to agree on a way of isolating the ‘idiosyncratic’ alpha that the manager has generated, and rewarding this well, because it is valuable.

This process might involve (in the private equity example) stripping out what returns the asset owner would have seen if the same capital had been deployed in listed equity markets at the same time (and adjusting for the effect of leverage and other persistent factor exposures).

If this could be done with a reasonable degree of accuracy and robustness, then the manager would be confident in his skill being rewarded (regardless of the market environment) and the asset owner would be confident that performance fees were being paid for genuine added value, not market returns or leverage.  Both sides ought to be happy with this approach.

In what many are describing as a ‘low return world’ investors will quite rationally seek to control fees and other costs. We believe that it is in the asset management industry’s own self-interest to think creatively and engage proactively with asset owners in order to achieve a better alignment of interest in fee structures.

 

Nick Sykes is the director of manager research at Mercer.