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The great fee debate: resetting manager and investor expectations

The recent push by the SEC in the United States and ASIC in Australia for greater transparency on asset management fees has reignited the debate about what is fair and reasonable. Managers are cast as greedy and investors are portrayed as ungrateful and focussed more on fees than on total returns. The battlelines have shifted for some in Australia with the introduction of MySuper, which adds to the pressure to reduce the total fees paid by fund members. Having been on both sides at different times in my career, I believe I can comment on the reasonable expectations each side should have.

Factors in picking a manager

I’ll first touch on three key factors when picking a manager: integrity, outperforming a relevant benchmark, and taking a small share of the outperformance.

The first is often accepted as a given, but clients of Bernie Madoff found this assumption can be financially fatal. A portfolio can recover from underperformance of an unskilled and honest manager, but not from a complete capital loss. This applies equally when taking advice from accountants and financial planners who recommend products, with many pre-crisis timber schemes and mezzanine mortgage funds in Australia relying on extraordinary commissions to drum up sales.

The second criteria superficially can appear to be simple. The trick comes when a manager compares itself to an irrelevant benchmark such as an investment grade bond index for an unrestricted bond fund or an overnight cash rate for an absolute return strategy. One recent study found that private equity earns around half its total performance from using leverage and from timing its entry and exit points (multiple expansion), thus muddying the comparison with a vanilla equity index. Some asset classes have much easier benchmarks to beat than others. For instance relatively few large cap managers materially outperform their index after fees yet almost all small cap managers do.

The last factor is where this debate really takes off. Once you’ve found an honest manager who you think is likely to outperform in the long term, how do you fairly reward that manager? What’s the right split between the base management fee and the performance component?

I’ll focus first on resetting manager expectations before moving on to investor expectations in Part 2 of this paper.

Resetting manager expectations

In my time acting as an institutional investor a number of things commonly frustrated me:

  1. Where I thought the manager was being paid way too much to get out of bed, and then took a decent chunk of any outperformance as well. Why are managers entitled to be paid so much merely for fund raising not for raising the value of my capital?

  1. Where I believed the manager was acting for their financial interest rather than giving investors a choice of what would best suit them. How can a manager pretend that something is unequivocally the best thing for me when they are clearly conflicted?

  1. Where I didn’t know what was happening with the investments and then faced stonewalling or hostility when I asked for information. Was the manager hiding something?

These situations and many conversations along the way shaped what I think about what managers should expect.

Managers are not entitled to a million dollar lifestyle until their clients are richly rewarded. If you can’t beat a relevant index in the long term you are wasting an investor’s time and money.

When I see managers charging 1% or more in management fees on multi-billion dollar portfolios I see that as excessive and unjustified. The cost of salaries for good people, decent systems and modest office space simply doesn’t require it. Some managers seem to believe that being able to craft a nice story about their investment process including a pretty slide pack means that they are doing their job. For investors to benefit, managers need to be rewarded for performance not presentation.

Investors are entitled to 90% of the outperformance over the index

This one is partly economics and partly conscience. Having done the calculations before setting up an asset management business I believe a 90/10 split well-rewards managers who outperform. But it is also a matter of conscience and I note that many managers will see 80/20 or 70/30 as the fair split. For the vast majority of managers, they are easily replaceable with another manager of equivalent or better skill, including index managers. Even in bullish markets when there is much capital around looking for an investment home, the demand/supply balance ultimately rests with investors.

Fees should be easy to explain and transparent

The recent SEC reviews of US private equity managers has highlighted the chutzpah of many managers in charging underhanded fees and the indolence of many investors in allowing the situation to exist unchecked. Managers should be able to fully explain their fees in one page or less. A standard base and performance fee model should suit almost all manager/investor relationships, with the incentive then placed onto the manager to minimise their costs of doing business. Where a specific additional service is required, this should be subject to investor sign-off.

Investors are always entitled to know where their money is and why it has been invested there

If a manager truly believes they have the recipe for a secret sauce and that revealing their positions will divulge the recipe, then that must be something everyone signs up to on day one. At least quarterly, managers should sit down with their investors and tell them where they see their sector positioned. I suspect many managers don’t do this as they fear being exposed as not having anything meaningful to say, or that an honest conversation might result in their investors recognising that other sectors present better risk and return prospects.

Investors are entitled to know the risk and return prospects and be given a choice to change

Whether it is has come about by bad experience or is simply an irrational fear, many managers are not able to say to their clients that their sector is not offering great value at a particular time. I’ve recently attended a number of presentations where US high yield debt managers have put forward the thesis that other cycles have made further gains from this point so investors should remain invested for now. Stripping away the hyperbole, their message could be rephrased “historically markets have become more overvalued then they are now so be greedy and squeeze the last few percent of gains out of this cycle.” This is short term, self-serving advice. Managers should trust investors that if they offer to give some cash back now when prices are high, they’ll be first in line to receive more capital when prices are lower and the prospects for performance fees are much higher.

Managers need to accept that investors may have valid fee or liquidity constraints that rule them out

I cringe when I hear the whining of some managers that investors should ignore fee, liquidity or return targets, often mandated by regulation. Why should an investor change their business model or lobby government for a change in regulation so that a private equity manager can earn high fees? Why should venture capital or agriculture managers be entitled to special treatment if historical returns don’t point to their sector outperforming in the future? Why should an investor take greenfield infrastructure risk because it is good for the economy rather than a good risk and return proposition? If a manager isn’t able to put forward a convincing case of future outperformance and appropriate fees they shouldn’t complain about investors passing on their ‘opportunity’. They should be looking to either change their business model or to pitch to other investors who have different views and constraints.

Managers should start changing their business models now to reflect a lower fee future

Managers need to start reducing their standards in their salaries, offices, flights, accommodation, entertainment and use of professional services ahead of a sea change in fee levels in the next decade. More large investors are increasing their index positions as they accept that the few managers that can materially outperform an index would be swamped if given a meaningful allocation of the investor’s total capital. An Australian superannuation fund told me that their cost of adding another dollar to an index equity product was 0.01% per annum. That’s increasingly what managers are competing against. Without the ability to survive in a lower fee environment, managers must excel in either performance or marketing, or accept that they are in a dying business.

In Part 2 next week, we’ll look at resetting investor expectations and find some middle ground.


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.


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