Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 75

Resetting investor expectations

In part 1, we looked at resetting fund manager expectations in the fee debate. In part 2, it’s the turn of the investors. After reading part 1, investors might be feeling vindicated and there may have been some smiling and nodding at the shortcomings of many managers. But this isn’t a one way street and there are some expectations that many investors should be changing for their own good.

Investors need to decide if they are fee driven or return driven

Many fund managers are partly right in arguing that some investors don’t prioritise total returns, but are instead more concerned with total fees. Focussing on total returns may make sense for an individual investor, but institutional investors are equally entitled to choose a low fee business model for their members and clients. But just as high fee managers are better off not pitching to low fee investors, low fee institutional investors should be transparent and decline meetings if the manager has no chance of meeting the target fee levels. This requires investors to know what they are willing to pay for each particular strategy. It also requires investors to know what split of base and performance fees they will pay and to be upfront in asking managers to work with that.

Low fee investors need to decide how to allocate their fee bucket

Low fee investors may choose to spread out their fee bucket over all sectors, or choose a strategy that has a core of very low fee index investments with a few satellites that will hopefully deliver the most return for the fees available. This will allow the investor to spend time choosing the best managers in their favoured sectors, rather than hearing pitches from managers who have no hope of fitting into the overall strategy.

If you want to beat the index you need to deviate from the index

Some investors seem to believe a fantasy world exists where managers can consistently deliver outperformance relative to the index. As any honest manager will tell you, there is no straight line of outperformance and deviating from the index means there will likely be periods of prolonged underperformance in order to deliver long term outperformance. Many top managers over a ten year period often underperform the average for a two to three year period at some stage during the ten years. Hugging an index means getting returns equal to an index minus the fees charged.

Top managers often don’t come wrapped in nice packages

I’ll mention two managers you’ve probably never heard of illustrate this point. Allan Mecham of Arlington Value Management had $80 million under management in 2012 with 12 years of track record and 400% returns over that period, leaving the S&P 500 for dead. Two years later he had $470 million under management and has continued to post extraordinary returns. Strangely enough, Mecham isn’t closed to new funds. Despite enormous outperformance over a very long period, institutional investors can’t deal with his demand for patient capital and his lack of Wall Street polish.

The next example is Michael Burry, formerly of Scion Capital. He was previously a medical student who took up investing as a hobby then decided to start running his own fund in 2000 after successfully blogging for many years. Like Mecham, his returns were off-the-chart good. By 2004 he had $600 million under management and was turning away investors. Starting in 2005 he began to short sub-prime credit default swaps. His investors, who had seen their investments more than double in four years, were enraged that their manager had moved away from solely stock picking and began to redeem their money. By 2008, despite having made a net 489% for the original investors in under eight years, Scion Capital closed and Burry now manages only his own money.

Both of these guys seemingly came out of nowhere and were not the usual asset manager types. Both managed capital with a long term view, took on concentrated positions and invested where their reading and ideas took them with little regard for typical investment styles. Regardless of the returns, the vast majority of institutional investors and asset consultants will not deal with them. Perhaps the real issue is that investing with people like this carries too much perceived career risk for investors, who work in an environment that relies on safety in the herd.

Top managers will inevitably be closed to new funds and will sometimes return capital to protect returns

In the last 12 months, Paradice in Australian equities and US hedge funds Appaloosa and Baupost have returned meaningful capital to their investors. They believe that their future returns will be negatively impacted by their existing size. Investors need to recognise that top performance often comes in the early years when outperformance is not diluted by size. For managers that do close, new investors that come late won’t be able to invest at all.

There is both skill and hard work involved in identifying top managers

There is arguably as much hard work and skill required to select top managers early, as there is required by those managers themselves when selecting underlying investments. As a guide, less than 10% of all managers can be expected to meaningfully outperform a suitable index after fees in the long term. If investors want to have an edge over their peers, they need to be actively searching for top managers and have clear measures to identify early what outperformance looks like.

Investors need to change their managers to get meaningful change in their fees

What most investors mean when they say they want lower fees is that they want their existing managers to charge less. This is a fairly naïve position to hold. In all walks of life people would prefer to pay less, but those who truly care about the issue do something about it. If a manager doesn’t have superior performance and won’t offer low fees to retain business, the capital should be redeployed to another manager or an index fund. For top performing managers, a balance needs to be struck bearing in mind the potential manager capacity issues and the possibility of an investor’s capital being returned.

For many investors, the way they choose managers needs to be changed so that fees are always one of the first points agreed. Another change would be to run an open, publicly advertised tender process. By publicly specifying what fees the investor is willing to pay and the outperformance expectations they hold, an investor is likely to discover new managers, strategies and fee propositions that they otherwise would not have considered.

Whilst many investors would say that this is what their asset consultants are paid to do, there is clearly a breakdown in this process as there has been very little change in fee levels or manager selection in the last decade.

Conclusion

The average manager and investor both have many things to reflect on and expectations to change in the great debate over fees. Managers need to start taking costs out of their businesses and resetting their expectations of what investors should pay. As well as lowering base management fees and eliminating obscure fees, managers should engage with their investors more often noting when their sector is good value and when it isn’t. Investors need to be more transparent about their willingness to pay fees, and be willing to change managers in order to have a step change in their fee levels. Investors should actively encourage low fee managers to pitch to them and take action to switch to such managers where the risk and return proposition is merited.

 

Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. Narrow Road Capital advises on and invests in various credit securities. His advice is general in nature and readers should seek their own professional advice before making any financial decisions.

 

  •   15 August 2014
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

The great fee debate: resetting manager and investor expectations

SMSFs have major role but not for everyone

Poacher turned gamekeeper changes his wealth model

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Will investors be better or worse off under new housing tax changes?

Housing tax reforms have sparked warnings of market turmoil and promises of greater fairness. But after modelling nearly two decades of property data, the results suggest winners and losers may not be who many investors expect.

Latest Updates

SMSF strategies

Division 296: the initial moves to make before the windows close

What if the best superannuation strategy isn't about earning more, but acting before your options disappear? Several overlooked planning windows are narrowing, with consequences that can last for decades.

Planning

Avoid unnecessary CGT with this estate planning clause

A simple estate plan can create a ticking time bomb. One overlooked clause can pit spouses against children, delay inheritances, and potentially leave a family facing an unexpected tax bill worth hundreds of thousands of dollars.

Exchange traded products

The hidden trade-off in fixed income ETFs

Some investment trade-offs are immediately visible. Others are embedded in the way a portfolio is constructed. Understanding the difference may explain why similar-looking investments can produce surprisingly different results.

Retirement

The mortgage free retirement is fading

What happens when a generation reaches retirement carrying obligations previous generations largely avoided? New research suggests we may need to rethink both how much we need in retirement and what life could look like.

Retirement

The key question to inspire a confident and purposeful retirement

Most people spend decades planning for retirement. Far fewer plan for what happens when they get there. The difference may explain why so many find the transition harder and less fulfilling than expected, despite careful preparation.

Latest from Morningstar

Making the case for a 'good enough' portfolio

Some investors spend years chasing the perfect strategy. Others choose a path that’s simply good enough and move on. Which approach is more likely to deliver both better outcomes and a happier financial life over the long run?

Investment strategies

Is the US market as expensive as CAPE says?

Many investing ideas survive for decades. But that does not make them right. A famous valuation measure implies that US shares are dangerously expensive, but the evidence may point to a very different conclusion.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.