We asked two European pension funds about their attitude to asset management fees and costs
Paying fees on dry powder is wrong
It is very important to control costs. However, if reducing costs is the main goal, then one would mostly invest passively. This would mean giving up the benefits of different investment styles and a diversified portfolio. A strategy of minimising costs should not affect the other goal, which is to maximise return with acceptable risk and a well-diversified portfolio. That said, once the asset allocation strategy has been decided upon, discussions around costs are the most important aspects of implementation. The strategic decision, on our side, is to do as much as possible internally. Managing assets internally has a positive impact on costs.
We also regularly discuss reducing fees with our managers. We have discussed switching from ad valorem fees to flat fees, but unsuccessfully. We would also be open to alternative fee structures with prospective asset managers. These could be symmetric performance fees, where we would share alpha as well as any negative performance with managers. Alignment of interest is important.
The impact of regulation around cost reporting in Switzerland has been felt. We have to report on explicit and implicit costs on all our investments and publish these figures in our annual report. In the first year of implementation, it was a challenge, whereas now it is manageable. The positive outcome is that we now have full cost transparency.
I do not see this regulation as being responsible for fee reductions in Switzerland. The lower expected returns on assets is perhaps a stronger stimulus.
There is still room for fee reductions across the market. There is greater potential in private markets, however. One disturbing thing is having to pay fees on committed, but uninvested, capital. This industry practice should disappear. We see some progress in infrastructure and real estate, where managers are starting to charge fees only on invested capital, but, there has been almost no progress in private equity and that is unhelpful.
There is scope for further reductions
As an asset owner and investor, managing the costs of managing our portfolios is critical to giving our partner funds the returns they require.
Rather than blindly trying to reduce costs by choosing the cheapest provider, our strategy is to maintain constant dialogue with managers. There are opportunities to discuss costs during procurement. But, we feel we have to ask about costs at every stage of the collaboration. It is also critical to make sure that the standard industry templates are filled in. There needs to be an agreement with asset managers that costs will be fully disclosed up front.
Alternative structures are a good way of controlling costs. We are trying to do away with ad valorem fees, prioritising fixed fees instead. There are significant issues with ad valorem fees, particularly in liquid assets. If a fund we invest in grows in size as asset prices rise, or if we decide to put more money in the fund, why should we be paying more in absolute terms? In those situations, there is a disconnect with managers, since they are earning higher fees without undertaking any extra work. We would favour having a fixed or CPI [consumer price index] linked fee structure.
“We would favour structures where managers participate in the downside as well as the upside”
We are not keen on performance-related fee structures, although we are looking at alternative performance fee structures in order to get a proper alignment of interest with managers. We would favour structures where managers participate in the downside as well as the upside. However, there is a timing issue. Managers should not get paid immediately for outperformance and fees could be withheld to compensate for potential underperformance. Solutions such as a clawback, deferred payment mechanism or a ‘performance bank’ would encourage long-term thinking by managers.
A further approach to control costs and to encourage long-term behaviour by managers would be to underwrite fixed-term management contracts. By offering a five-year guarantee, subject to nothing going wrong, we could negotiate on fees and ensure better alignment of interest.
The constant mantra is getting to know what the actual costs are. This is a prerequisite for being able to manage them. That is why we support industry initiatives designed to improve cost transparency.
At the most basic level, investors should have full awareness of what is the gross return versus the net return. This way, they can start to estimate the size of the implicit costs, such as transaction costs or market impact, which are significant. It is not enough to look at net returns.
Generally speaking, we have come a long way in terms of getting full transparency of costs. However, we still have a long way to go. There is perhaps greater scope for cost reductions in alternative strategies. However, I believe there is still the reach for further reductions across the industry, even in liquid assets and passive strategies. We are some way off knowing the cost of all the layers in the cost chain.
Interviews by Carlo Svaluto Moreolo