Are money managers’ fees fair?

Investment management fees are often structured in ways that reward asset managers in good times but spare them pain when they underperform, say many Canadian DB pension fund managers and investment consultants. They also argue that, although some fees for institutional investors have declined, they remain too high in general—and don’t always reflect great manager skill.

“The compensation models that we have are all imperfect,” says David Kaufman, president and CEO of Westcourt Capital Corporation, an investment consulting firm.

The main problem with fees, explains the director of investments at a $1.7-billion Ontario pension plan who spoke on the condition of anonymity, is that they’re asymmetrical. “The asymmetry stems from being very well rewarded for outperformance while still collecting a base fee when underperforming.”

What Are You Paying For?
Base fees always apply, but they vary from client to client. “It’s not as black and white as, ‘Here’s your fee schedule; here’s what you’re paying,’ ” says Duane Green, head of Franklin Templeton Investment’s institutional group in Canada.

There’s always negotiation, which becomes more pronounced as an investor and a manager explore additional services, he adds. For example, if a client with a Canadian equities mandate adds a second mandate, the fee schedule becomes more nuanced. “They may say, ‘We want you to aggregate assets or look at our overall relationship,’ ” Green explains.

Despite these nuances, the underlying rule is that the larger the asset volume an investor allocates to a manager, the lower the base fee. If the client invests $100 million, the fee might be 0.5%; if it’s more, that percentage decreases. This applies both to commingled (pooled) funds—used by most pension funds because they allow various institutional investors to pool assets in one account— and separate accounts, which are used by the biggest pension funds. Generally, pooled funds charge fees quarterly; separate accounts bill annually.

Pooled funds spread returns evenly among all investors. “The actual vehicle might generate the same performance, but not every investor will have the same net results,” says Green. That’s because each participating investor has a different fee schedule based on how much he or she contributed. “All of the fees are billed outside of the fund.”

And while custody services are covered in pooled funds, investors with separate accounts need to pay for a custodian. This, says Green, adds extra charges.

On top of the base fee, both pooled funds and separate accounts can charge a performance fee—a percentage of outperformance above a certain benchmark that’s negotiated ahead of time. Say a fund’s benchmark is 5% and the management contract stipulates a 10% performance fee. A manager delivering a 6% return would get 10% of the extra 1% of return.

The logic behind this structure is that the investor could have gotten 5% by buying something much less risky and more liquid. Earning more than 5% requires skill, so that’s where the manager takes a cut, Kaufman explains.

Separate account performance fees are sometimes based on high-water marks, the highest ever peak in value an account has reached. So if the manager has a bad year after a good one, no performance fee is charged until the account surpasses that high-water mark. This structure helps to ensure that managers aren’t compensated for poor performance.

Some see performance fees as a worthwhile incentive, since they indicate when managers are performing well. Others argue that they can create a potential misalignment. “There’s an incentive for [managers] to take more short-term risk in order to get paid more today,” Kaufman explains.

But portfolio managers don’t see it that way. “I can see why people would say that,” says Green, “[but] I’m speaking only for our firm. If you’ve hired us to manage money in a certain mandate, we couldn’t just decide to change the investment philosophy and try to take on additional risk just to generate returns in order to get a performance fee.”

Having a base fee only isn’t perfect either, because it can create situations where “a firm isn’t necessarily incentivized to deliver outstanding performance so much as to just try to achieve asset growth,” says the Ontario pension plan investments director. He explains that mediocre performance is an issue because making a profit net of fees typically requires outstanding returns.

Kaufman agrees. “You may not be great, but you’re not going to get fired— so you can just keep getting your 1%, and go on with your life, and play golf,” he says. When a manager’s only incentive is not to lose money, he adds, this can encourage short-term thinking.

“So, in the short term, [managers] are unwilling to buy an equity that is trading at a discount but has long-term potential that’s excellent,” says Kaufman. If, in the short term, the stock gets further undervalued, managers might face accusations that they’re underperforming the market, he adds.

“I hope that this is not the case,” counters Green. “And I hope that our industry hasn’t become that cynical.”

Kissing Many Frogs Costs More
Apart from structure, other factors that determine fees are whether the assets under management are traditional or alternative, and whether the mandate is passive or active. For a portfolio of traditional assets, fees are generally about 35 basis points if all the manager does is replicate an index, says Kaufman.

With active management, fees can go up to 100 basis points—especially for geographies that require a more hands-on approach, such as emerging markets, he adds. With alternatives, annual management fees typically exceed 1%, and an added layer of performance fees is common. It’s typical to pay a 2% management fee and a 20% performance fee for private equity, and a 2% management fee and a 30% performance fee for venture capital, says Leo de Bever, CEO of the Alberta Investment Management Corporation, which manages public pension fund assets in Alberta.

To overcome these fees, investors need superior returns. “Average outcomes [in alternatives] are often not worth the fees that you pay, so you are typically looking for above-average outcomes,” explains Ryan Bisch, Canadian alternatives boutique leader with Mercer Investments.

Alternatives cost more because managing them is labour-intensive. Unlike traditional assets, they don’t lend themselves to passive management. Alternative managers have to actively look for deals and investigate private companies, real estate properties or infrastructure assets, says Janet Rabovsky, senior investment consultant with Towers Watson. “They have to kiss a lot of frogs before they find their princes.”

And this due diligence requires a skilled staff. These firms even go so far as to hire different experts, such as engineers if they’re facilitating the purchase of a biotech company, Rabovsky adds.

Despite all that work, fees for some alternative mandates have fallen in recent years. “A core income-generating infrastructure [fund] used to be, let’s say, 1.5%, and it’s now broadly 1%,” says Rabovsky. Part of the downward pressure has come from Canada’s biggest pension funds, which have internalized asset management and created competition for money managers.