Making it cut both ways
Flat fees have been the norm for managing pension fund assets. But now pension funds appear to be showing an increasing interest in performance fees.
This is understandable. After years of underperformance by allegedly active asset managers pension funds are becoming impatient. They want asset managers to manage their assets actively rather than hug the index and are prepared to pay performance fees to managers who add some value.
The fee structures used by hedge funds have already shown how performance fees can work. So-called 'high watermark' contracts pay the hedge fund manager a bonus only when the investors make a profit.
However, there are fears that high watermark type contracts could encourage traditional asset managers to take more risks than their risk budgets allow. A less risky approach might be a system of ‘step up’ fees, whereby asset managers are paid no more than a basic administration fee if they merely meet the benchmark and an additional performance fee if they outperform the benchmark.
Some leading asset managers see this as the way forward. Robert Parker, deputy chairman of Credit Suisse AM, has predicted that the ‘step up’ performance fee could replace flat fees within a couple of years.
We wanted your views. Are performance fees the best way to get the best out of asset managers or do they encourage them to take risks that are inappropriate to the management of a pension fund portfolio? Should pension funds be able not only to reward outperformance by their asset managers but to penalise underperformance?
Your responses suggest that flat fees are on the way out. Overall, there is a belief that performance fees will grow in importance. A majority (60%) of the pension fund managers and administrators who responded to our survey agree with the proposition that performance fees will become the main way of rewarding active asset managers in the future.
The manager of a UK pension fund says: “I am sure performance fees will make up a greater and probably increasing proportion of fees.” However, asset managers must accept that performance fees are not the icing on an already generous slice of cake. The manager of a Belgian pension warns: “Performance fees will become the norm if fund managers can accept a low basic fee. It will not if they expect a nice basic fee and performance fees on top of it.”
We suggested that flat fees without a performance component are no longer an appropriate reward for active asset management. This suggestion draws general agreement. A large majority (73%) agree that virtue is no longer its own reward. Some suggest that a redistribution of assets is all that is needed. A UK pension fund managers says: “Sometimes good performance might result in additional funds being allocated to the manager who does best. In an environment of an increasing number of closed funds, it should be remembered that this could include no disinvesting from the mandate that consistently outperforms and raising funds from the less satisfactory performing mandates.”
Other managers feel that asset managers should satisfy a number of conditions before performance fees become the norm. One manager at a Belgian pension fund spells the out: “First, performance should be easy to verify. Second, if a manager is rewarded for out performance he should indeed be penalised if he underperforms. Third, the period over which out performance is calculated - and rewarded - should be sufficiently long.”
If these criteria are not met, asset managers can expect strong opposition to performance fees, he adds ominously.
Our managers provide some cautionary tales. One pension fund manager recalls: “From our own personal experience I can tell you about two very similar, if not identical, mandates: one with a reasonable flat fee, the other with a very low base fee and a performance fee. One of them outperformed consistently, while the other was very unstable. Quarters with very high outperformance were followed by quarters with strong underperformance.
“You can guess which was the most expensive, by far, and which one eventually outperformed its benchmark.”
The contentious issue of whether asset managers should be penalised financially for underperforming draws surprising support, with a majority (60%) advocating a rap over the knuckles. One Dutch pension fund enterprisingly proposes ‘malus’ fees as the reverse of the coin to bonus fees. The simplest and most effective penalty is seen as the withdrawal of the mandate. Yet one UK pension fund manager warns of over-hasty reprisals. “Beware of being too short termist in setting and invoking financial penalties,” he says.
Asset management is not the only area where asset managers can stumble. Administrative errors can lead to losses equal to those incurred from mis-reading the market. The suggestion that asset managers should be penalised for operational or administrative errors as well as poor investment performance drew strong support, with three in four respondents (75%) agreeing. The manager of a Belgian pension fund says that action should be taken if things become “too messy”.
Again there are caveats that momentary lapses should be distinguished from chronic mismanagement. One pension fund manager says that the test should be “if errors are significant in financial terms or consistent – that is, if systems weaknesses are not corrected in a reasonable timescale once they have been identified”.
The ultimate sanction, the loss
of the mandate, is seen as the most effective remedy. One manager at a Finnish pension fund suggests “you can always change the
The idea of ‘step up fees’ for asset managers, with a basic administration fee paid to managers who met the benchmark and a performance fee if they outperform the benchmark, gains the largest vote (85%) However there are dangers. A UK pension fund manager warns: “One should beware of the performance fee becoming too great a proportion of the total fee. This could lead to index tracking to ‘bank’ past out performance rather than seeking to continue to manage to maximise returns. Similarly if penalties kick in at a given level of underperformance a manager would be tempted to move to a more neutral position if they were close to the limit to reduce the chance of underperformance over the period to be measured”.
There is some concern among respondents (60%) that performance fees based on a percentage of excess returns could encourage managers to take more risk than their risk budgets allow. However the manager of a Swiss pension fund points out that “it is up to the sponsor to monitor investment style and adherence to guidelines”.
The suggestion that performance fees in general are too risky for pension funds gets short shrift, with a large majority (80%) disagreeing. And an even larger percentage (83%) are prepared to pay for active management. Most (83%) say it is worth paying active management fees. One UK pension fund manager says: “If one is prepared to take a long-term view and has faith in the manager’s decision making processes which inform their investment decisions, it is worth it.”
Mischievously we threw in a firecracker to our survey and asked you whether you thought active asset managers possess any real skills that enable them to outperform or whether they are just plain lucky when they do.
Asset managers can breathe again. Only a small minority off respondents (18%) see asset mangers as lottery players in the world of investments. However, some of our respondents suggest that luck plays an important part in asset managers’ success – or lack of it. “Real, consistent all-weather skills are very rare. Luck or momentum capturing are more frequent,” one pension fund manager observes.
Another respondent’s reply has a nasty sting in its tail. “Asset managers do have skills but they tend to be skills that result in success only in certain market conditions.”
The manager of a German pension fund is more diplomatic: “We hope that asset managers have both skills and luck.”
However the manager of an Italian pension fund deserves the last word. His observation brings to mind Napoleon’s dictum that he wanted only generals who were lucky. “Asset managers should have real skills, but a lucky one is better,” he says. Roll the dice.