The big squeeze on active fees
In the first months of the crisis, at the tail end of 2008 and into 2009, Australia’s super funds sat back, slowing and in many cases halting the normal process of fund manager review and appointment. While on the surface superannuation funds appeared to be inactive, significant debate was taking place across the industry, the results of which are starting to be seen in the decisions being made by super funds.
With concern about the performance of active managers during the crisis one area of focus has been the renewed focus on passive management to generate beta returns. AustralianSuper recently announced that it had reviewed its Australian equity portfolio, reducing the number of managers and increasing the proportion of the Australian equities portfolio allocated to passive investment from 25% to 50%. The NSW Local Government Superannuation Scheme (LGSS) also announced a move to increase the use of passive management in its Australian equity portfolio.
Peter Lambert, Chief Executive Officer of LGSS says “we have had a number of fund managers on both our international and Australian equity roster, with a blend of styles. We would typically see half of them under-perform and half out-perform in any one period, which meant that what we were getting was a quasi index type of overall performance, while paying active management fees. We felt that by investing approximately half of the fund’s assets in a passive style of approach we could then employ two, maybe three specific active managers. We would have effectively the same level of risk as we would have if we were a fully active portfolio, but with a much lower fee.”
Asset Super have taken an alternative approach, terminating a number of smaller mandates in a review of its international equities managers and increasing the relative size of mandates. CEO John Paul says the fund switched asset consultants last year with new consultant Mercer advising the fund to take on higher rated, better performing active managers to improve its performance. In changing the composition of the portfolio Asset Super sought to reduce fees through larger mandates. John Paul says “one of the outcomes that we can achieve through bigger mandates is better fee outcomes for the fund, namely we can get cheaper management costs by having a bigger lump of money.”
The impact of a smaller number of mandates is likely to be a greater focus on researching and monitoring managers. LGSS anticipate that they are likely to transition active managers more often. Lambert says “What we are looking to do is almost try to anticipate periods where we think that a (particular) style of management would struggle to out-perform and try to take proactive steps to address that. In the past we would wait and possibly sit on a manager too long. My goal is to terminate managers when they are out-performing, not after they have gone through under-performance.”
LGSS have established a process to identify broad economic themes that will play out over 3 to 5 years and then seek to choose a best of breed manager that can work best within that. Lambert says “There will be periods where different style will come more into favour, so we may terminate that manager not because we have any problems with that manager but because we feel the way they operate may not be conductive to out-performance over the next period.”
While super funds are considering the relative composition and styles of their portfolios negative returns has meant renewed focus on the structure of fees.
Fiona Trafford- Walker, CEO of Frontier Investment Consulting, which is owned by a group of industry superannuation funds, says “we are looking down the barrel of another negative return this year. We have clawed a lot of it back. At one point across our client base we sitting at about minus 20, we are now sitting at minus 11 or something like that.”
Trafford- Walker has called the industry’s existing business a broken model. “For many years fund management businesses have had their revenues go up just because the markets have gone up. I think that it is time for those days to be over. The funds management industry is is one of the only industries that you sell hope. You sell hope that you can out-perform, you don’t sell a guarantee. When you buy a fund manager you never really know how things are going to pan out. You can have your due diligence and you hope they do well, but hope is not a strategy.
“We have been strongly encouraging our clients and managers to think about a better way of charging clients. It might be a fixed dollar structure that ratchets up each year by some inflation measure, which covers the cost of the manager. There is a second component which is performance related and that does two things; it gives the managers more certainty about the fees they are earning at the base level. It also aligns them so that if they do perform well, they do get performance fees and if they don’t perform they just get a base fee.”
Trafford-Walker believes that investment managers that respond favourably to Frontier Investment Consulting’s fee model are likely to do well. “If you have a got a good manager that brings a much more sensible fee, then clients would be interested that. Clients are interested in paying a fair fee for a fair service.”
Frontier’s positioning on fees comes as industry super funds seek to exercise their increased bargaining power in fee discussions with managers. At LGSS, Peter Lambert says “we are finding that across the board that managers are much more willing to enter into dialogue about what we think are reasonable fee arrangements, hopefully fee arrangements that align the interests of both parties, I think that certainly in the past fund managers had the upper hand in the fees and it has now gone back to a buyer’s market.”
While Asset Super feels that its bargaining position has improved John Paul says that it is not a universal picture. “We are finding that some managers are more receptive to fee discussions than others. I still don’t think that we have got to the stage where I could truly say as a generalisation that we are in the driving seat. I would like to think we were but I don’t think that’s yet arisen but we have seen a willingness on the part of some fund managers to be a bit more receptive in terms of talking about a lower fee basis however there are many managers in our total line-up that we have approached to look at reductions and they have steadfastly refused to consider them.”
The focus on fees and performance is likely to have a significant impact on the investment industry. Jana CEO Ian Patrick says “it would be an indisputable fact that there will be a shakeout of investment managers. We are undoubtedly going to see fewer investment managers post the global financial crisis than we had pre the global financial crisis and that is going to be a function of sustainability at lower revenue levels, when your revenue is halved if you were an active equity manager and you haven’t taken on new clients that will put some business models under pressure.