Special Report, Fees & Costs: Winds of change
Pension funds do not seem happy with the external managers who look after most of their members’ savings. In the US, CalPERS decided it cannot scale up hedge funds for the cost and complexity involved. Railpen in the UK estimates that it is paying 300-400bps in indirect costs on top of headline asset management fees. Peter Borgdorff, head of Dutch healthworkers’ plan PZFW, has floated the idea that external asset managers should give something back when times are bad.
These three are big funds but the sentiments are shared across Europe. More than two thirds of pension funds in an IPE survey in May agreed with Borgdorff’s call for ‘clawback’ provisions.
But observers of the world of finance have been wondering for over a century ‘where the clients’ yachts are’ – what is different today? The answer probably has a lot to do with the financial crisis of 2007-08. Since central banks around the world decided to buoy up markets by becoming their biggest buyers, public securities have performed handsomely.
Bonds and equities have delivered 8-8.5% annualised from the low-point of March 2009, whereas central banks have not had such a benign effect on alternatives such as property, hedge funds and private equity. Annualised returns from these assets have been in the range of 1.5-4%. The flood of cheap funding has washed the illiquidity premium associated with many alternatives. No wonder then that this has been the focus of so many of this year’s grumbles and policy changes by pension funds.
“Core assets have been rewarded by QE while illiquids have not,” says John Belgrove, senior partner at Aon Hewitt. He has sympathy with those disappointed by this turn of events but believes the diversification argument still holds and warns against ditching illiquids now because they have underperformed during the last period.
At a glance
• Pension funds seem increasingly to feel they are getting a raw deal from asset managers.
• This is particularly the case when it comes to alternative investments.
• Factor investing has opened up new possibilities for generating most of the return available from alternative and active long-only investment, but at a fraction of the cost.
• And yet there is little evidence of costs coming down, or of any shift away from ad valorem towards performance fees.
• There is also surprisingly little attention given to ‘hidden’ costs that are not included in headline fees.
• Some pensions regulators are taking a tougher line on costs, but it may only be the shift to individual saving within DC schemes that finally puts decisive pressure on the asset management industry’s charges.
Some pension funds beg to differ. Austria’s €6.4bn VBV has been divesting from hedge funds in recent years. CIO Günther Schiendl is clear that he is not against all such strategies – there has been a variety of returns from the VBV roster. But he has learned that those with skill deserving of their fees are few, while those generating 1-1.5% annualised returns for 300bps of embedded costs “are not good enough”.
Schiendl also makes a connection with the crisis in looking for explanations. “Prior to 2008, the hedge funds made 400bps from the interest on cash on margin,” he observes. “That uncelebrated source of return has now all but disappeared.”
Perhaps the best hedge fund houses never made it to Vienna. Schiendl admits this could be the case. “But everyone knocked on CalPERS’ door,” he remarks. “So what is their rationale?”
CalPERS gives three reasons why it is exiting hedge funds – size, cost and complexity. For a $300bn (€240bn) fund, the contribution from $4bn in hedge funds was not worth the candle. When the scheme researched scaling up its commitment to make a greater impact, it decided cost and complexity were not in its favour. Instead, the fund decided to do more of what several others, including VBV, had done, and run more capital in-house.
What is significant here is that more CalPERS money is going to be allocated to factor investing. ‘Complexity’ is thus – arguably – a euphemism: CalPERS found much of its hedge fund returns could be explained by factors such as value, size and momentum.
Factor investing offers a way for investors to cut down on fees while retaining the bulk of returns. As Schiendl puts it: “However much skill an external manager supplies, it is always the smaller part of the total.”
And factor investing is seen by one leading consultant as the game-changer not just in hedge funds but long-only too.
“There has been growing recognition over the past two to three years that not all outperformance can be attributed to skill,” says Andy Barber, investments partner at Mercer. “It may become hard for managers whose performance record can be explained by permanent factor exposures to justify high fees.”
Neither Belgrove nor Barber, however, expects long-only fees to come down. In fact, data from Greenwich Associates suggest pension funds in continental Europe are paying more, year-on-year, in certain asset classes. The average fee in emerging market equities rose from 50.6bps to 57.6bps. In high yield bonds, the average rose from 40.4bps in 2013 to 50.5bps in 2014.
Lydia Vitalis, a consultant at Greenwich cautions against presuming too much from the figures. “This is high-level data and does not account for a multitude of influences such as service-level agreements or performance fees,” she says.
Research from consultancy Lane Clark & Peacock suggests costs for Dutch pension funds were 53bps in 2013. KAS Bank finds they were 54bps. Depending on which analysis you prefer, this is a slight rise or fall on 2012. Perhaps more significant is the range across the Dutch universe – from 0.04% to 1.14% of fund assets.
More accurate insights – nationally or internationally – are hindered by the prevalence of negotiating. Only a minority of houses render such bartering obsolete by having a fixed fees for all institutional clients globally.
This leads us on to the structure of remuneration. A new research paper from Cass Business School in London looks at the utility function for asset managers in offering a flat fee; a combination of flat and performance-related fee; or a pure performance-related fee, including losses to the asset manager (refunds to the client) should the portfolio lose value. Unsurprisingly, in most cases flat fees suit the manager while two-way performance-related fees suit the client.
Nick Motson, one of the paper’s authors, says that conceptually he finds it strange that performance fees are not the norm in active management. “Ad valorem fees encourage asset gathering,” he says. “That makes sense for index-tracking managers. But if a house is active, where is the commercial endorsement of your capability to outperform?”
In IPE’s research, 60% of European pension plans said they were in favour of performance fees. Vitalis at Greenwich Associates says that interest in the topic is high. And yet ad valorem fees remain the dominant structure for institutions.
Alternatives structures are well known. In the US, mutual funds offering performance fees have to abide by a so-called fulcrum rule whereby any profit-sharing must swing both ways. This would be the equivalent of the third option in the Cass paper – although in practice most houses offering such funds also take a percentage of assets as an annual management fee.
Those are regulations for the US market. What about Europe? Chris Sier of KAS Bank and David Pitt-Watson of Hermes have been reviewing the academic literature on pension fund costs.
For Sier, costs are even more obscure than fees. “If you imagine total costs are a 30cm ruler, most analysis is on the 5cm covering ad valorem fees,” he says. “Another 5cm covers performance-related fees but then there come transaction costs.”
Railpen has found that indirect costs – which are not accounted for in performance figures and which do not form part of the headline fee – can indeed be more than double that fee, at least in asset classes such as private equity, where transactions are more complex compared to trading on a stock exchange.
Not only is the quantum startling but so is the fact that pension funds and their advisers have to dig deep even to make an educated guess on the total cost of their investment. In its audited figures, Australia’s AUD$200bn (€138bn) Future Fund, a global leader in transparency, does not include indirect costs because they can only be estimated at present.
Sier reckons that however startling this new exploration, there may be a final ‘5cm’ of expenses that are even less well investigated.
If you cannot measure it, you cannot manage it. But will the euros really look after themselves while pension funds mind their cents?
Dutch pension plans are now obliged by their regulator to get a handle on underlying transaction costs (9bps on average during 2013, according to LCP).
But Toine van der Stee, CEO of BlueSkyGroup, fiduciary manager for a dozen Dutch schemes, believes that loading more investigative responsibility on pension fund boards is counter-productive. Pension fund boards might become better informed but what will they do with the knowledge? Van der Stee says it is more worthwhile to improve the customary practice of good asset allocation strategies. “It’s not about cost but value for money,” he says.
It may be that regulatory oversight has had as much influence as it can over the fees and costs debate in the world of collective pensions saving, and that the real impact will come elsewhere.
Roger Urwin, head of global investment content at Towers Watson, advised both CalPERs and Railpen on their belief structures, established prior to the recent announcements regarding alternative investments. Yet, in spite of his influence in the defined benefit (DB) world, he believes it is the growing importance of defined contribution (DC) that will drive the debate on costs.
The UK government is currently working through the difference between fees and costs in a consultation paper. Urwin expects others to follow. “DB contracts are professional-to-professional dealings,” he observes. “Individual members in DC [funds] need more protection. Governments have a legitimate role to play if this market has not sorted out parameters.”
Anxious vigilance thus passes from DB trustees to pensions ministers and their civil servants. A final thought for their worry tray is that Urwin reckons the UK’s proposed cap of 75bps on member-borne costs is far too high.