Alignment of interest

The mechanism for sharing risks via fees in the pension industry is weak, says Fiona Trafford-Walker. Asset-based fees don’t reflect managers’ ability, and clients don’t get enough of the benefit of scale. So how should managers be paid?

Those who know me well call me Fee, and so I do get a few wisecracks every now and again about “flat dollar fees” and so on. So when Amanda approached me to write this piece on fees, my first thought was “Can I please write about something else?” I have been talking about fees for a long time!

I first actively hopped on the fee soap box in 2009 after I became incensed following a phone call from a fund manager telling me they were laying off 20 per cent of their staff (post GFC) but that I didn’t need to worry, as those staff hadn’t had anything to do with the investment process, so their departure wasn’t going to hurt client performance.

My first thought was, “Why are clients paying for them in the first place then?”

So I wrote a client paper in September 2009 called Managing Investment Management Costs and Aligning Interests in which I stated:

“The purpose of this note is to provide some thoughts on current fee structures used to reward investment managers and align them with the interests of clients and to propose some alternative fee structures that we think would better align the interests of a client with those of the investment managers used. Importantly, we strongly believe that clients should be focused on net risk-adjusted returns to members … Readers might think that this is simply a missive aimed at reducing fees. It is not – it is about paying the right amount for performance. In some cases, this may mean higher fees to some firms if they perform well for clients. In others, it is an appropriate mechanism for pushing out the weaker performers and strengthening the investment manager universe over time.”

I still think that today – in a pension/superannuation fund world, the funds (and the members and sponsors) are the ones that provide the capital and take the risk in allocating to external fund managers.

They deserve to be rewarded for taking that risk with better returns, and high-performing fund managers deserve to get paid fairly for adding value.

But the mechanism for sharing in general is weak – asset-based fees have little linkage with the manager’s ability, clients don’t generally get enough benefit of scale and there is not usually a penalty for under-performance other than termination of the relationship.

This is the case in Australia and in many other countries. Unfortunately, ad valorem fees remain the norm, and performance fees have also not been well-enough aligned as a general rule (the base fee is not low enough, and in many cases the “sharing” of alpha is not really what sharing is all about).

At the same time one of my industry colleagues in Australia, Ken Marshman at JANA, had come to a similar conclusion so we worked together to develop the Frontier/JANA fee principles, which were launched in 2010. (Ken is now the chair of the industry superannuation fund, REST which has A$37 billion in funds under management and two million members.)

The aim of these principles was to assist institutional investors in negotiating investment management fees.

We didn’t intend for these to be prescriptive and emphasised that negotiation should always remain the means by which buyers and sellers of services should come to agreement.

Many Frontier and JANA clients formally or informally adopted these principles or some variation thereof.

I know many other funds also started to think more about fees and fee structures, and modest progress was made. But not enough.

So here I write, six years later, pretty much saying the same thing despite the aforementioned modest progress.

And yet the future looks different, with the following important differences that will affect the years ahead for global investors generally and Australian investors specifically.

1. There is a reasonable prospect that medium-term returns will be much lower than we have seen since the Great Moderation began in the mid-1980s. The investment objectives set by pension funds will be harder to achieve, and so all are looking at how to continue to meet those targets with various investment ideas, but also by looking long and hard at what it costs to manage their portfolios. For funds that outsource money management, investment manager fees are the largest components of that cost by a long way. This has now become a business issue for many funds, so it’s on the agenda for boards, chief executives, chief investment officers and internal investment teams. This elevation to the board is one of the main differences between now and six years ago.

1. 2. As the Australian superannuation industry has grown, there has not been enough capture of that scale through reduced costs. We also know that fund manager margins remain very, very high (and if anything, many have expanded since the GFC), especially when compared to any “normal” industry. This desire to capture the benefit of scale is now a significant focus at many funds.

3. There is also now an implied regulatory imperative to bring down fees charged by superannuation funds here in Australia. Signals from the Australian Securities and Investments Commission (a key regulator) and more formal statements from both sides of government, as well as a decision to immediately implement a Productivity Commission review of the “efficiency and competitiveness” of the superannuation system that had been proposed for 2020, are all part of this focus.

1. 4. Finally, there has been much in the press in Australia from various research bodies comparing the costs of Australian superannuation funds to global funds and arguing they are too high. I don’t think they necessarily compare like with like, but the popular press has run with this nevertheless and it’s a hot topic.

So these things are all in the ether and are impacting discussions around board tables here in Australia and no doubt in other markets around the world.

We have already seen many changes – funds are continuing to explore all sorts of options to reduce fees and costs, such as internalisation, disintermediation, renegotiation, co-investments, better capturing of scale benefits and so on.

Some are walking away from managers and products with inappropriate fees and/or terms, others are canning entire sectors with poor-value-for-money prospects and many are deciding on manager shortlists after looking closely at the value for money.

This will no doubt continue apace.

In our own business, we have changed the way in which we report fees and costs to clients in our manager due diligence documents. We now rate managers formally on five key criteria related to fees, prospective alpha and risk-adjusted alpha, the sharing of that alpha, and value for money.

A manager needs to pass at least one of these tests to be rated. No doubt other consultants have taken similar actions.

Good managers have little to fear – I think most clients will still take a value for money perspective and pay for skill in order to meet the investment objectives set for members and sponsors.

But funds will be much more discerning about the firms they choose to work with, about what they pay and, importantly, how they structure the fee.

As I said in 2009, this is a good opportunity for the funds management community to develop innovative fee structures that work for clients and for the managers themselves; however, the window to do this is no longer as wide open as it was.

Funds have already taken charge and are making changes.

Fiona Trafford-Walker is the director of consulting at Frontier Advisors, Australia’s largest independently-owned asset consulting firm. She is frequently rated as one of the best consultants globally.