Why US funds can drive harder fee bargains

Many US fund sponsors believe they have not received fair value for the fees they paid to investment managers in recent years, a survey by Callan Associates found.

In 2006, 71 per cent of sponsors surveyed by Callan felt the investment management fees they paid were justified, and 47 per cent thought fees across the industry were justified. Now, only 50 per cent feel their fees are justified, and 33 per cent perceive industry-wide fees as fair, Callan’s 2009 Investment Management Fee Survey found.

But sponsors are not intensifying their fee bargaining with managers across all asset classes. Consistent with Callan’s 2006 findings, sponsors negotiate fees with 66 per cent of their managers on average. Most of these negotiations pertained to US large cap equity and core fixed income products. Here, alternatives managers are notably absent. In response, 80 per cent of managers change their fee structures every two to four years. But 20 per cent of respondents never change their published fees. But their investors’ vigilance of fee levels is also not exhaustive.

While 31 per cent of sponsors review fees each year, 17 per cent never do, even though manager fees account for up to 88 per cent of sponsors’ cost of doing business. When negotiations take place, about one third of managers award a “relationship discount” to clients who invest in multiple products, in the form of a reduction of the sum of all individual fees. Despite an increase in the published fees for actively managed US large cap, small cap and non-US equities products for larger accounts, the actual fees paid for these products has declined for larger accounts since 2006.

While published fees declined for US broad market fixed income strategies, the actual fees paid remained flat. For managers, fee revenue has gradually fallen from a 2006 peak of between 21 per cent and 30 per cent. In 2008, revenue dropped to levels below those seen in the 2002 bear market, and will likely decline further. Managers estimate their year-over-year fee revenue will fall in 2009 to between -10 per cent and -20 per cent. Pre-tax profits, which were also between 21 per cent and 30 per cent from 2005 to 2008, are expected to fall below 20 per cent in 2009.

But fund sponsors have never been fully aware of the fee revenues they sustained for managers, generally perceiving that managers typically earn between 10 per cent and 20 per cent less than they really make. In the next 18 months, sponsors aim to consolidate the number of managers they employ for their small, mid and large cap US equities and US core plus fixed income, but intend to hire more managers to run global and non-US equities, other types of fixed income, real estate, private equity and hedge funds.

Among sponsors and managers, performance-based fees are becoming more popular as an alternative to standard fee structures, with 59 per cent of fund sponsors using performance-based fees for at least one account and 64 per cent of managers offering them. Such alignment of performance with payoffs addressed some major fee concerns held by sponsors: that active managers delivered enough value to warrant their expense, and that fee structures used for alternatives were reasonable and aligned with fund goals.

Otherwise, investors seek to know whether the fees they pay are competitive with the marketplace. Meantime, managers are worried about fee and margin compression (particularly since asset levels have fallen while operational costs have increased), the consistency of fees given “most favoured nation” agreements, and the competitive pressure from cheaper replication strategies.