Ahead of the Curve: Fund managers must face fire too

Matthew Spencer argues that investment managers should feel the pain when they under-perform and not just share in the upside

The idea of performance-related pay seems straightforward. Yet it has become one of the most controversial topics in investment management. As I see it, the debate should focus less on ‘flat versus performance’ fees and more on fee structure design. 

Poorly designed fee structures create a mismatch between manager and client incentives that is almost impossible to overcome – even with the best intentions. A well-designed fee structure, on the other hand, can create closer alignment of interests and deliver real value for money. Why has our industry got this so wrong?

A big part of the problem is the economics that underpin the dominant fee model in the industry. Charging a fixed percentage of assets under management comes with several advantages that are far more appealing to managers than to clients. Such fees are easy to administer, produce steady cash flows, and have tremendous operating leverage. And that is precisely the problem. The key risk facing managers is losing assets, and an easy way to do that is by taking big bets against the crowd and being wrong. Managers therefore have a powerful incentive to stick with the safety of the herd.

This can be seen in the benchmark-hugging behaviour that is all too common in the industry. According to our research, global equity strategies available to UK investors typically have a tracking error of about 1%. It is rare to see many above 3%. 

Data on active share paints an equally bleak picture. A 2015 study led by Martijn Cremers, professor of finance at the University of Notre Dame in the US, showed that about 20% of mutual fund assets worldwide could be classified as ‘closet indexers’, as defined by active share of below 60%. While tracking error and active share are not perfect metrics, it is hard for managers to deliver attractive returns if they are not making decisions that are substantially different from their benchmarks.

The typical performance-based fee structure attempts to give managers precisely this incentive to focus on delivering superior returns. If managers succeed in beating their benchmark, they stand to do enormously well. If not, they can still cover their costs with the base fee and live to fight another day. This creates a classic ‘heads I win, tails you lose’ asymmetric pay-off. It can be mitigated to some extent by introducing a high watermark but, even so, managers almost never fully feel their clients’ pain. For example, if a manager initially earns substantial performance fees early in the relationship with the client, a high watermark does little to help clients in the case of subsequent underperformance. 

If neither flat nor performance-based fees align interests particularly well, is there an alternative? One solution is to design a fee that pays the manager a reasonable base fee to keep the lights on and a performance-based component that is paid into a reserve. Fees could then be refunded to clients after periods of subsequent underperformance. An even better idea would be for managers to charge no base fee whatsoever and only collect fees when they outperform. 

Of course, this introduces a lot more business risk for managers. Even the best managers can experience prolonged periods of underperformance, yet still need to cover their fixed costs. But that is not such a bad thing. Most businesses depend on delivering value for clients to survive. Investment management should not be any different.

Performance-based fees, even those with refunds, are not perfect. But simply abandoning them altogether in favour of flat fees is also a bad idea. Instead, managers should find creative ways to design incentive structures that reward outperformance, penalise poor performance, and are proportionate to the value that the manager has added over the client’s investment horizon. 

This is easier said than done from an operational perspective, but it is not impossible. We owe it to our clients to rise to the challenge and get it right. At a time when many investors are questioning the value of active management, it is imperative that managers hold their own feet to the fire.  

Matthew Spencer is the head of the institutional client team at Orbis Investments

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