The UK FCA’s interim report on asset management highlights the sensitivity of fee levels and structures in the institutional world. Joseph Mariathasan reports
At a glance
• FCA report highlights fee issues.
• Managers have been taking excessive amounts of the alpha generated.
• What is a fair split?
• Are performance fees the answer?
The UK Financial Conduct Authority (FCA) published an interim report in November on asset management which highlighted asset management fees. The findings included that, on average after charges, there was no significant return over the benchmark for institutional active investment products. Although the FCA finds that UK active funds have, on average, outperformed their benchmarks before charges, they nevertheless underperform after charges by about 60bps on an annualised basis.
So it does seem that active managers can outperform, but they keep all of the outperformance and more for themselves, on average, rather than their clients. Fees are clearly a sensitive point for both asset owners and asset managers and always will be. But it is only fair for the providers of capital that they are given fully transparent information on all costs that their capital is subjected to when it is given to external parties to manage.
The worry for capital owners is that they are paying too much for active management and that does certainly seem often to be the case. Willis Towers Watson (WTW) found the split between managers and clients was iniquitous when the firm first started analysing this a few years ago, although the situation is improving, according to Luba Nikulina, global head of manager research. It used to be the case that the split was skewed heavily in favour of asset managers, and it was not uncommon for them to take over 70% of the added value that they created. Over time, WTW has found that this has improved, although it has highlighted to its clients that there is a clear market deficiency if service providers take over half the value they create.
“The reality is that it is probably fair when the asset manager takes no more than a third, as the asset owner is the provider of capital, so they should have the bulk of the expected added value,” says Nikulina.
The FCA report says that while some investors may choose to invest in funds with higher charges in the expectation of achieving higher future returns, academic research suggests that higher-charging funds do not, on average, generate higher performance compared with cheaper funds in the same investment category. The FCA’s own initial analysis indicated that, while there is no clear link between price and performance, on average the cheapest funds generated higher returns (both gross and net) than the most expensive funds. Moreover, they found little evidence that firms compete on the basis of price, in particular for active products.
Is it fair to complain that active managers underperform the benchmark indices on average? The FCA itself made the point that passive funds, after costs, would generally underperform against the relevant market benchmark. The market index is a theoretical construct which does not take into account the costs of investing. But Yves Choueifaty, founder and president of TOBAM, argues that comparisons of active management against indices are misplaced in any case. As he says, the average active manager cannot outperform the benchmark by definition because the benchmark is determined by the sum of activity carried out by both active and passive managers; as passive managers have no impact on the direction of the benchmark since they exactly match it, the direction of the benchmark is driven by the sum of all the bets taken by active managers. It is obvious that it is impossible for the average active manager to outperform (or underperform) the benchmark which, after all, is the output of all the activities carried out by active managers.
If all investors adopted a purely passive approach to investment, the market would become highly inefficient. But few institutional investors would be prepared to pay active fees purely for the common good as their duties are seen as specifically towards their own beneficiaries. What the FCA report did find iniquitous is that some investors appear to be paying ‘active’ prices for products that are only partly active in nature. Such ‘index-hugging’ products are similar to passive products, but just take small positions either side of the benchmark. As the FCA points out, many investors in expensive ‘partly active’ products would likely achieve greater value for money by switching to a cheaper passive fund in the same investment category.
What is the right value for fees? WTW finds the range for active long-only strategies is 20-100bps. Smart beta costs may be as little as 15-20bps with the more basic end at 10bps. A smart beta strategy may have 1,000 stocks, while more sophisticated quantitatively managed strategies may have 200 stocks and charge 25-30bps. Active managers would charge 40-60bps for a developed global equity strategy. Adding emerging markets would add 5-10bps on top for all strategies.
Beyond this lies the alternatives world where the standard used to be a basic fee of 2% per annum with a performance fee on top of 20%: “Two-and-20 is not fair and would mean that the manager is taking more than 70% of the alpha,” says Nikulina. But, as she adds, it rarely occurs now. Fees are getting lower, but there is a limit: “Can you undertake private equity for a 50bps fee? Probably not and you would not want to give money to a manager who says they can do it for that.” What has not moved much is the 20% carried interest.
“It is not what we would have liked to pay, but it hasn’t moved much. What has moved is the management fee. The baseline now is 1.5% and it is possible to negotiate fees as low as 1%. Other hidden fees have also been removed in many cases, such as deal fees.”
What matters more than the level of fees is ensuring alignment of interests between managers and capital owners, says Nikulina. There is a big difference between a small boutique focussing on 10-20 stocks as against large firms with tens or hundreds of billions: “As an investor, you are sometimes keen on paying higher fees to the boutiques to not only get exposure to the underlying stocks but also the skills of the manager.”
For Nikulina, the ideal fee structure is one that is closely linked to the costs of running the business in terms of attracting good quality staff, incentivising them, and having a robust infrastructure. The ideal structure she argues, is one where there is a fixed element that can cover the costs and then a small element of performance that is calculated over a long-term time horizon so that it can be based on skill rather than luck, while the effects of market beta and the allocation of risk are stripped out. The fixed fee should be linked to the size of the team and the intensity of the activity.
Performance fees may seem an answer but they also attract controversy. They have been criticised for giving managers an incentive to take more risk; historically managers have been able to benefit tremendously from a windfall fee payment in good years while having the option of simply walking away from the downside if they underperform. One firm that has attempted to solve this and ensure true alignment of interests with its clients through a performance fee structure is Orbis Investments. Instead of paying performance fees directly to the manager, Orbis’s refundable reserve fee structure incorporates a ‘fee reserve’ in between the two parties, explains Dan Brocklebank, director at the firm.
Such a structure means that if the manager underperforms, fees can be paid back to the client in the same proportion that they were charged and paid into the reserve. This fee mechanism is available with a zero base-fee option and the actual crystallisation of fees from the reserve only occurs at a steady pace. Clearly, if there is an extended period of underperformance, the manager will find their revenues and profitability to be unsustainable, but as Brocklebank argues, that is as it should be.
Whatever fee structure is chosen for active management, the real challenge is that outperformance is not persistent in the long-only space. That is why investors are better off looking at the lifecycles of investment management firms and investing early on. They would be taking on some risks, but are more likely to capture a firm when it is aligned with its investors and less likely to be just asset gathering. Nikulina says: “What tends to happen, when a firm is successful, there is the temptation to get more and more capital which dilutes returns.” For capital owners, that may not be a comforting thought.
Netherlands: PME aims for enhanced transparency on costs
• Pensioenfonds Metalektro
• Location: The Hague
• AUM: €44bn
• Combined asset management and transaction costs: 40bps
• Administration costs: 30bps
• Total costs: €161m
Frank van Alphen
The €44bn Dutch metal scheme PME has significantly extended its data-gathering of asset management costs in recent years. Costs have decreased but the fund wants to expand its investments in the relatively expensive asset class of private equity. The net returns are attractive, according to Marcel Andringa, executive board member for asset management at PME.
PME has increased the amount of data about asset management costs it publishes in its annual report fivefold, to five pages, in the past four years. Andringa does not expect that he will need more reporting space soon. “I think we provide sufficient information now. If we produce more details, we risk publishing competition-sensitive data. That would harm us if we have to negotiate with asset managers. The information we provide at present already goes beyond the recommendations of the Pension Federation.”
PME is quite transparent on costs, which it divides across asset classes. In addition, the scheme assesses whether its costs match those incurred by similar pension funds in the Netherlands and abroad, using data from the Canadian benchmarking firm CEM.
PME’s costs have dropped significantly. In 2011 it paid 78bps for asset management. Since then the level has dropped to about 40bps. The fund attributes the reduction to an increased focus on the issue. “After all, costs are a certainty; the result is not,” says Andringa.
Together with its fiduciary manager MN, PME has addressed costs in various ways, starting with removing expensive asset classes. “During the past years we have divested holdings in, for example, hedge funds and commodities. We do not just take costs into account but also look at yields. The additional costs incurred from these investments do not generate additional returns.”
PME has also reduced costs by simplifying its portfolio and investment policy. “We invest passively, unless we expect that active management will generate added value. This means that large parts of the portfolio with liquid investments, such as equity and bonds, are being passively managed.
“Another way to keep costs down is to negotiate closely with asset managers, a task we have outsourced to MN.” Some managers regret that pension funds focus too much on costs. “I can imagine that asset managers use this argument, but I have the impression that they are still making decent money in the sector. Costs can well be reduced further.”
The pension fund also pays extra attention to reducing transaction costs as a consequence of portfolio changes. Andringa says: “In the past we did not factor in these additional costs. Today we make an estimate in advance. If it takes three or four years to recoup transaction costs, it could be a reason to refrain from allocation adjustments.”
Andringa cites a reduction in managers per asset class as an example. “Fewer managers means lower fees. If you have a billion invested across four asset managers and you want to scale down to three [and] if it takes years before you have recouped the additional transition costs, it may be sensible to wait until you reduce your investments in that asset class anyway. This way we try to avoid unnecessary transaction costs.”
Focus on costs does not mean that the more expensive asset classes are off-limits. “We expect that asset management costs will rise slightly during the coming years,” says Andringa. “We want to increase our private equity holdings as we assume that unlisted companies will generate a surplus return of 3% relative to equity.
“PME has less than 2% of its portfolio invested in private equity, which returned 12% net last year. Therefore, we want to increase our allocation to about 5%. The consequence will be that costs will rise.”
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FCA raises questions about fee levels