Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 176

Why traditional asset allocators get low returns

In dozens of meetings over the past four years, I’ve learnt a lot about how family offices and institutional asset allocators (that is, groups that aggregate funds and make investment decisions on behalf of individual clients) think when picking external fund managers. While no two asset allocators are the same and certainly no two family offices are alike, there are often similarities. After the small talk, the first questions from the potential investors are a good marker of how they think.

The common and hidden questions

The first questions from family offices are typically ‘what are your returns?’ and ‘what are your fees?’ The hidden question is ‘do you make money for your clients or just for yourself?’ Family offices are looking for managers who have a track record of meaningfully outperforming their benchmark and charge competitive fees. If you don’t have these, you aren’t going to be part of their asset mix and you may as well leave at that point.

The first questions at meetings with institutional asset allocators are different. The most common questions are ‘what are your funds under management?’, ‘how many clients do you have?’ and ‘what systems do you use?’ Here the hidden question is ‘if you underperform will our peers underperform as well?’ The most important filters for many institutions are what their peers are doing and their career risk, not the product itself. There’s often a checklist of unspoken milestones that fund managers need to meet before asset allocators will consider investing with them.

Checklists are a good thing. I use them when making investment decisions to see if I’ve covered the key risks. Having a checklist and using it when making decisions relating to fund managers is a good thing too – it’s something investors in Bernie Madoff’s Ponzi scheme undoubtedly wish they’d used. The key questions to ask about fund manager checklists are; ‘why are things on the checklist?’ and ‘what is the outcome on returns and fees as a result of using the checklist?’ If using the checklist means you end up investing with managers that deliver low returns and charge high fees, you are buying the packaging, not the product.

Emerging managers often disqualified

In the US, it is common for pension funds to run publicly advertised tenders to select asset managers. This is great for competition, with the benefits flowing through to asset allocators and their beneficiaries. Tenders allow for asset allocators to specify what they want including milestones. Asset allocators often specify that proposed fees will have a substantial weight in determining fund manager selection. This helps drive down the fees, albeit at the risk of discouraging some high return/high fee funds from tendering.

However, the required milestones may disqualify a substantial number of high return/low fee fund managers. This often comes by specifying a high threshold for minimum funds under management or a minimum number of other pension funds that are already clients. The two diagrams below help explain the issue. Firstly, here’s the outcome of the tender for fund managers based on their funds under management and ability to generate alpha.

Managers with both high funds under management and high alpha generation (excess returns) will win the tender. If the focus is solely on fees, an index fund is likely to win. Emerging managers will either not submit or will be disqualified due to the required milestones.

Good managers closed to new investments

The next matrix shows the reality of the funds management industry when it comes to negotiating fees and terms.

The bottom right hand corner is where everybody wants to invest. As a result, managers that have both high funds under management and high alpha are typically closed to new investments and in some cases may be giving capital back to their investors. Existing investors who ask for lower fees are likely to be reminded of the waiting list or to have their capital returned.

For fund managers that have both high funds under management and high alpha and that continue to accept new investments, their returns will suffer. Eventually, they will migrate to the low alpha column as their size will impede their ability to take advantage of market mispricings. Asset allocators with high milestone thresholds are essentially limiting themselves to these fund managers. This means consigning themselves and their beneficiaries to managers with lower returns and medium-to-high fees, or to index funds.

Early-stage investing

This is where family offices and non-traditional asset allocators can outperform traditional asset allocators. By looking for managers with high alpha but low funds under management they can achieve high returns with reduced fees. The more enterprising investors will also look for seed opportunities, where a share of the equity or a royalty stream of the fund manager is granted in return for allocating a game-changing mandate to an emerging manager. Early-stage investing also gives investors priority access to the fund manager when their funds are large enough that closing the fund or returning some of the invested capital is required.


The different approach to investing by family offices and institutional asset allocators can be categorised as focussing on the product or the packaging. By focussing on the product, family offices and non-traditional asset allocators look for emerging managers that can deliver high returns as well as lower fees. By focussing on the packaging, traditional institutional asset allocators are often limited to investing with lower return, higher fee managers or with index funds.


Jonathan Rochford is Portfolio Manager at Narrow Road Capital. Comments and criticisms are welcome and can be sent to This article has been prepared for educational purposes and is not a substitute for tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.



How inflation impacts different types of investments

Choosing your investment strategy is like a road journey

Watch the performance of performance fees


Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates


The 'Contrast Principle' used by super fund test failures

Rather than compare results against APRA's benchmark, large super funds which failed the YFYS performance test are using another measure such as a CPI+ target, with more favourable results to show their members.


RBA switched rate priority on house prices versus jobs

RBA Governor, Philip Lowe, says that surging house prices are not as important as full employment, but a previous Governor, Glenn Stevens, had other priorities, putting the "elevated level of house prices" first.

Investment strategies

Disruptive innovation and the Tesla valuation debate

Two prominent fund managers with strongly opposing views and techniques. Cathie Wood thinks Tesla is going to US$3,000, Rob Arnott says it's already a bubble at US$750. They debate valuing growth and disruption.


4 key materials for batteries and 9 companies that will benefit

Four key materials are required for battery production as we head towards 30X the number of electric cars. It opens exciting opportunities for Australian companies as the country aims to become a regional hub.


Why valuation multiples fail in an exponential world

Estimating the value of a company based on a multiple of earnings is a common investment analysis technique, but it is often useless. Multiples do a poor job of valuing the best growth businesses, like Microsoft.


Five value chains driving the ‘transition winners’

The ability to adapt to change makes a company more likely to sustain today’s profitability. There are five value chains plus a focus on cashflow and asset growth that the 'transition winners' are adopting.


Halving super drawdowns helps wealthy retirees most

At the start of COVID, the Government allowed early access to super, but in a strange twist, others were permitted to leave money in tax-advantaged super for another year. It helped the wealthy and should not be repeated.



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.