Investment management is an unusual business in that it doesn’t typically offer customers their money back if they’re unsatisfied with the product or service.
This seems strange given how easily and objectively we can measure value added or destroyed. Of course, demanding a refund for poor investment performance may be more complicated than returning a defective toaster or sending back a bottle of corked wine, but the principle should be the same: customers shouldn’t bear all of the risk for disappointing results.
Unfortunately, the dominant fee model in investment management has essentially nothing to do with performance. The vast majority of active managers today charge a fixed fee, calculated as a percentage of assets under management. While the fixed-fee model is simple, predictable and easy to administer, it has a number of serious flaws. Managers collect windfall profits during bull markets and are incentivized to gather more assets through sales and marketing efforts. For even the best-intentioned managers, when you’re paid based on the amount of money you manage, the incentive to grow can be overwhelming — even if it comes at the expense of investment performance.
The classic combination of a fixed-base fee plus a performance fee with a high-water mark offers some improvement (even if the levels common in the hedge fund space remain egregious). By tying manager compensation to performance, the fee encourages a tighter alignment of interests with clients and can discourage some bad behaviours. Regrettably, it can amplify others. The most troubling issue is this type of fee structure is asymmetric. Managers share in all upside, but none of the downside. If all goes well, the manager makes a killing. If not, they can simply shut the fund and start over, leaving clients holding the bag.
Professor Andrew Clare of the Cass Business School in the United Kingdom calls this the “heads we win, tails you lose” problem. In a 2014 paper* of the same name, he and his colleagues ran mathematical simulations comparing the results of various fee models, including those mentioned above. Their analysis concluded the industry’s most prevalent model — the fixed fee — is generally best for the manager and the worst for the investor. Let that sink in for just a second. The most common fee model — the one we’ve relied on for most of the industry’s history — is the best for the manager and the worst for the investor.
Clare and his team also analyzed an alternative fee model that offers investors a considerably better value proposition: a “symmetric” fee. Under this structure, a client pays when the manager outperforms, and receives a refund at the exact same rate when the manager underperforms. While more complex than a fixed fee model, a symmetric fee means the manager shares equally in both good and bad performance, creating a close alignment of interests between client and manager. This also ensures any fees paid are proportional to the value that has, or hasn’t, been created for the client. The manager can only do well when the client does, too.
Versions of the symmetric fee are found in both traditional and alternative asset classes, but are still exceptionally rare. That said, there have been some promising developments in fee innovation in recent years as some in the industry push for a closer connection between fees and performance.
As part of a scathing landmark study of the U.K. investment management industry in 2017, the Financial Conduct Authority noted, “the prevailing [fixed] fee model incentivizes firms to grow assets under management, which is not necessarily aligned with investors’ best interests.” The FCA went on to comment that, “there is substantial innovation in [the] development of more symmetrical performance fee models … that try to better align a fund manager and fund investors’ interests.” Later that same year, Fidelity Investments, one of the world’s largest investment managers, launched a symmetric performance fee across a variety of actively managed funds. Japan’s Government Pension Investment Fund, one of the world’s largest investors, with more than US$1 trillion in assets, also recently introduced its own fee structure to pay active managers almost entirely based on performance. Finally, we have seen more managers, including Westwood Holdings Group Inc. and Aquamarine Capital Management, introduce performance-only fee models with no base fee at all — structures in which the manager is only paid if it outperforms.
Still, efforts to change the status quo more broadly have seen remarkably little traction overall, and we have to wonder how much longer this can last.
Mercer’s head of equity manager research, Richard Dell, and (now retired) investment consultant, Nick Sykes, summed it up well in their 2018 article, Building a better fee model, which offered many of the same criticisms of the current fee options. “The combination of suppliers earning excess revenue and unsatisfied customers is normally a recipe for a shake-up in an industry; either new, low-cost providers will come in, or a different [fee] model will emerge. Such an evolution has yet to take place in the investment industry, but it’s only a matter of time; the current position is unsustainable.”
Perhaps the time is finally here.
Notwithstanding this year’s crash in March, global stock markets have been in an almost uninterrupted bull market for more than 10 years, and prices are high across many asset classes. Fees can seem like little more than a rounding error when returns are as robust as they have been, but in a lower-return world we should expect fees to come under even more pressure. Simply lowering the levels of the same flawed fee model does not seem like a sustainable solution. More creative thinking — along the lines of what the FCA, GPIF, Mercer and others have proposed — is long overdue.
Investors shouldn’t sit back and wait for a fee revolution. Instead, they might consider taking the same approach as unsatisfied customers of most other businesses: speak to the manager and ask for a refund.
* Orbis Investments provided funding for Andrew Clare’s research.
Chris Horwood is an investment counsellor at Orbis Investments. These views are those of the author and not necessarily those of the Canadian Investment Review.