Why managers’ fees trump alignment

For asset owners, there is nothing ideal about the fee deals they strike with funds managers. If there were, fee agreements between managers and investors would exhibit a clear alignment of interests across the dimensions of investment and business risk, time horizon, client service and retention and, critically, a fee which reflects the real value that managers add to portfolio outcomes, says Michael Block, general manager – investments at FuturePlus.

In a world where humans are motivated by their own interests, the best and perhaps the only way an asset owner can ensure the managers they hire will provide a mutually beneficial service is to set monetary incentives for them to do so, he says. But the fee models that investors agree to may not have their interests at heart. “Just as we get the politicians we deserve, perhaps we also get the funds managers we deserve,” Block says. Most fee models in existence, particularly the asset-based kind, prioritise the short-term interests of the individual (the manager) over those of the many (the fund members a fiduciary investor serves). Block finds this objectionable, particularly because he believes that active management is not only expensive, it’s also not that important to portfolio outcomes.

He points to a 1986 study by Brinson, Hood and Beebower, Determinants of Portfolio Performance, which found that 93.6 per cent of portfolio outcome is the result of asset allocation. Block also agrees with Towers Watson when the consultant asserts that, in recent years, investors have been paying alpha fees for beta, since the main driver of returns has been the strength of the markets and, in some cases, added leverage. But in spite of these findings, portfolio construction and investment strategy only receive a comparatively small portion of a fund’s fee budget compared to active management fees. In Block’s professional experience, most funds spend more than 80 per cent of their time and money on active management fees and manager selection. He says a $3 billion superannuation fund will typically pay only $200,000 each year for asset consulting services as it hones its strategic asset allocation, and $10 million each year on active management fees.

“This is very interesting, given that active management is at best likely to make a contribution of less than a tenth of overall portfolio outcomes.” The evolution of active management fee structures has not, so far, produced a mutually aligned model (see table below). Block prefers the latest permutation, in which managers are paid a cost-recovery fee until the expiry of a three-to-seven year “lock-up” period, when a performance fee will be awarded. This performance fee would be paid – or not – after taking into account the managers’ returns against an agreed, long- term benchmark. But this would receive pushback from managers, he allows, because it might not meet their short-term interests. Stuck at this impasse, the alignment debate will continue.

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