Investors should discuss how they share alpha with asset managers. But it is easier said than done, finds Carlo Svaluto Moreolo
At a glance
• Investors can extract better value from active management by discussing how to split outperformance.
• Most investors say the majority of outperformance should accrue to them.
• There is a degree of flexibility depending on strategies and type of alpha.
• Successful alpha sharing conversations can take place within transparent cost frameworks.
Investors and managers tend to argue over the overall price of active outperformance. But when discussing the value of active management, a more fundamental point seems to be neglected. Conversations on how outperformance should be split between the investor and the manager seem to be less frequent. Yet the question of how the parties should divide the economic gains from the investment activity is a core one.
Several consulting firms, however, do bring that question to the negotiating table. Among them is Cambridge Associates. Alex Koriath, head of the firm’s UK and European pensions practice, says: “Ultimately, when you look at an active manager, the question you need to ask yourself is: what do you think is a fair split of the alpha? How much should you keep as an investor, how much would you allow a manager to keep?”
IPE put the question to investors. More than 70% of the respondents said that, when negotiating performance fees, the investor should keep at least half of the alpha. Several said investors should keep more than 80%. Some, however, believe the percentage depends on the level of fixed fees and the type of strategy.
Koriath agrees, to an extent. One variable that could affect the balance, he argues, is the consistency of the alpha. He says: “You could argue that an investor might be more willing to give away more of the alpha if it is delivered consistently and steadily over long periods of time. Whereas, if it is a very risky alpha, with lost of underperformance in between, the investor might be less willing to give up alpha.”
However, Koriath says the basis for a discussion should be a 75% to 25% balance in favour of the investors. “But there are different views. Some of the managers believe they deserve at least a third of the gains.”
The reason why investors should focus on discussing that balance, according to Koriath, is straightforward. “It’s a discussion that recognises that investors are ultimately the provider of the risk capital, but also that the fund manager needs to have certain incentives to achieve that alpha. The 75/25 split is a good starting point, then the investor need to think about the details, such as how the balance should be shifted, depending on managers, asset classes or alpha targets, ” he says.
Koriath says it is best to have that conversation early in the process. “You need to have the conversation now, with a forward-looking attitude. You need to analyse what managers have delivered in the past and what the expectations for the future are. You could almost do some stochastic modelling to see what the likely outcomes are.”
Most asset managers are likely to respond positively. “The interesting thing is, once you bring the conversation to that level, you will find that most smart fund managers have thought about it in a very similar way. And they will have some ideas about it,” says Koriath.
It is essential that this approach does not just work in the presence of performance fees. By analysing a manager’s track record and forecasting future performance, investors can evaluate the alpha-sharing balance even when only management fees are involved. Koriath notes: “You should look at both base and performance fees in relation to the alpha that is generated. With performance fees, it’s actually harder, as they are notoriously difficult to analyse.”
The concept could resonate with investors, as a potentially useful approach to extract more value from active mandates. However, there is no escaping the fact that cost transparency is necessary to assess the value of an active mandate.
Markus Hübscher, CEO of Pensionkasse SBB, the CHF17.1bn (€15.5bn) pension fund for employees of the Swiss railway system, illustrates the idea neatly. He argues: “Performance is something you can always measure. Measuring costs is more difficult, particularly in certain asset classes. If a manager charges 2% and promises a 5% return, it may sound like a reasonable situation, even though it is not clear whether you will get that gross return or not.”
“If there are hidden costs, however, the expected performance you need to achieve the same net return is higher. As the expected performance deviates by even one percentage point, the picture looks quite different. There is a certain amount of leverage involved in these calculations.”
That is why the requirement for investors to calculate and publish a total expense ratio (TER) that has been implemented in Switzerland has become so important. Hübscher continues: “Now that we have full transparency, investors can assess what net performance figure is justified given the total amount of fees, and they can therefore ask themselves: do I want to give more than 50% of my expected performance away in fees? Before the implementation of the TER framework, we couldn’t have that discussion, because we did not have the numbers.”
In other words, a discussion on how to share outperformance generated in an active mandate is only useful in the context of a transparent cost framework. And cost transparency is not always readily available.
Furthermore, notes Hübscher, studies in Switzerland show only a slight positive correlation between fee levels and returns. In other words, funds with higher fees do not perform much better. Once again, this puts the alpha-sharing approach to the test. Should investors be willing to part with a higher share of alpha when they are dealing with higher-fee strategies. The answer may be positive if investors are convinced higher fees led to higher returns, but this is not always the case.
In general, SBB employs a top-down approach to choosing active managers. Hübscher says: “We have active management in place, where we believe that passive management, structurally, may offer less favourable performance. This happens for markets such as high yield, mortgages and more in general alternative investment, where passive managers cannot replicate the index.” However, further consideration is made on how individual managers propose to generate alpha.
Publica, the CHF37.9bn (€34.7bn) Swiss institution that manages 21 Swiss public pension funds, has a similar approach. The institution tends to prefer rule-based investment, but it has employed active managers in sectors such as real estate, emerging market debt and private debt. “In those markets, rule-based implementation is either impossible or the benchmarks are not efficient,” says Publica’s CEO Stefan Beiner.
“However, active managers really have to justify their value, and show us that they are not just taking additional risk. It’s not just about cost transparency, but also about improved risk models. It is much easier to show the factor tilts of an active portfolio. Therefore, active managers have to demonstrate they are generating real alpha.”
These points suggest that the changing fortunes of active investment management are inextricably linked with the debate on fees and costs in institutional investment. Innovative fee structures may be welcome. But the debate will focus on issues of transparency and transaction costs as long as investors will feel comfortable that they are getting what they paid for.
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