Two common mistakes institutional investors make are focusing on headline manager fees and forgetting about costs embedded elsewhere in the system.
“That sounds obvious, but Australia has got just about the most sophisticated pension fund market in the world, and I actually hear more focus on aggregate manager fee levels and comparing across funds here than I do in any other market, which is a bit strange,” said Craig Baker, global chief investment officer of Willis Towers Watson at the consultants’ Ideas Exchange in Sydney.
Rather than looking at headline fees in isolation, Baker suggested there were four areas that could help institutional investors decide which type of mandates should warrant higher fees.
The areas to consider are:
- The level of active risk the manager was taking
- The type of asset class being managed
- The amount the mandates gave
- The amount of gross exposure
Firstly, the higher the level of active risk taken by a manager, the higher the fee an institutional investor should be prepared to pay.
“If you actually allow for the fact that fees don’t tend to increase linearly with the amount of risk taken, it’s pretty clear to see that better value comes from the higher risk mandates, because ultimately you can just blend them with passive management, get the same amount of active risk wanted, but at a much lower aggregate fee level,” Baker said.
Asset class type
Higher fees were also deserved in some asset classes which required greater management, for example, direct lending, because there was no low-cost passive equivalent.
In these cases it was less about how much value added there was against a passive; rather it was understanding what illiquidity premium a particular asset class would get and deciding whether that was worth the fee to gain access to it, Baker argued.
Mandates that give more
Thirdly, if an institutional investor has two mandates and one is giving more within the mandate, more should be paid for it.
To illustrate this point, Baker gave the analogy of choosing between two houses: “If they’ve got different specs, one’s got a swimming pool the other one hasn’t, you should expect to pay a bit more.” [For the one with the swimming pool]
Stewardship is a good example of this, as what is “ultimately” being paid for in a long only equity mandate is active management of the companies invested in.
“You can actually take board compensation as a proportion of market cap of the companies [and vote on it]. That percentage can actually be bigger than the fees you are paying your managers. So stewardship could be a big deal in what you pay for.”
Alternative asset classes are another area where more should be paid for a mandate, as they have more degrees of freedom, for example, public equity versus private equity.
In each case the costs are coming out of the performance, but the big difference is in a private equity mandate these costs are included in the fees paid to the private equity manager, whereas in a public equity mandate these costs are coming out of the profit and loss statement of the company. One makes it look like the manager fee is quite low and the other makes it look like the manager fee is quite high.
“Is this a big deal? We’ve done some work that suggests this could be between 50 and 100 basis points – it’s a massive deal. So when you are thinking about the fees of a private equity manager you might need to take 50–100 off to compare like with like,” Baker said.
Higher gross exposure
Continuing with the house analogy, if you buy a house that is twice as big as another house, all other things being equal, you would expect to pay more.
“Equally, if you are getting more exposure to the markets for the amount of capital you’ve handed over … if you’ve got higher gross exposure you should pay higher fees.”
“When you also think about the fact that you pay performance fees on total returns, you get better value if the majority of total return comes from alpha rather than beta. You take those two things together and you should be paying higher fees for high gross exposure, low net exposure mandates.”
Take, for example, two market neutral hedge funds charging the same fee of one per cent base and 10 per cent performance, which have equal skill and are able for every 100 per cent gross exposure to produce 4 per cent alpha (equivalent to a long-only manager outperforming by four per cent per annum).
The only difference between them is they are running different gross exposures, with manager A at 150 per cent and manager B running at 300 per cent gross exposure.
(For the purposes of argument, the example has taken a simplistic approach with zero cash returns and zero borrowing costs.)
This gives a return of 6 per cent for manager A, and 12 per cent for manager B.
“What would I point to? Well the first thing is that you have high fees, 1.5 and 2.1 per cent per annum respectively, certainly a lot higher than you would pay in a lot of mandates. The other thing is B is 40 per cent more expensive than A,” Baker said.
“However, if we look at it slightly differently, the fees as a percentage of actual value added from each of these managers, you get 25 per cent and 17.5 per cent. You can make two observations there. Firstly, they are actually pretty cheap. This is much better value than you would get from a typical public equity manager. And the second observation is that B is 30 per cent cheaper than A.
“So here you can see [that] depending on how I frame it I can give you three conclusions. Firstly, A and B charge the same. Secondly, A is cheaper. Thirdly, B is cheaper.
“Headline fees are meaningless.”