Gandy Gandidzanwa & Itai Mukadira
Fees destroy value.
Rather put bluntly, but maybe a little bit of basic math will help justify the tone. Did you know that for every half-a-percent charge in fees a member’s accumulated retirement savings drop by a fifth by the time they reach retirement age.
Put simply, if a member where to retire with $1 million where the annual fees were say 1% of assets, this dramatically drops down to only $800 000 if the fees had been 1.5% of assets instead.
It is no surprise then that the regulator, the Insurance and Pensions Commission (IPEC), has come out guns blazing on the industry demanding downwards fee reviews. Just to be clear though, this is by no means an endorsement of the approach the regulator has taken in addressing the fees issue. Suffice to say though that, as part of the key industry stakeholders, we shared our views on the regulator’s expenses draft guideline when it was out for public comment. We would be more than happy to share with anyone what those views on the draft guideline were. That, of course, is a topic for another day.
For now, it’s back to what’s up for discussion today – performance-based fees. More specifically so, investment management performance-based fees.
The ancient custom of “eating only what you kill”, inherited from our hunter-gatherer forefathers, is generally as applicable today as it was then. Of course, this is more so in some aspects of life and less so in others. To what extent then is this noble custom applicable in the management of pension funds investments? How are the asset managers charging fees currently, and how should they be charging these fees? What criteria should they be applying in coming up with, and justifying, their fee charging models? Are these fee models pro- or anti-members? How do the fee models, for instance, demonstrate a genuine pursuit of alignment of investment manager’s interests with those of the members?
Where are the Members’ Yachts?
A story is told of a visitor in New York more than a century ago. After admiring yachts Wall Street bought with money earned providing investment management and advisory services, he wondered where the customers’ yachts were. Of course, there were none. There was far more money to be made in providing investment management and advisory services than there was in receiving the investment advice.
The story is as relevant today as it was back then. Maybe in our case, we would recoin it to – where are the members’ SUVs? Even after more than a century of the story being told, the answer hasn’t changed – there are none.
A Critique’s Perspective
Performance-based fee structures have been frowned at in the recent past and reasons for that have ranged from their complexity and lack of transparency to that they are generally skewed in favour of the investment manager. Issues of benchmark used, hurdle rate applied, participation level proposed, asymmetry, depth of application of the high watermark principle, and whether the end total fees are capped have dominated these conversations.
Clearly, critics of performance-based fee structures have brought to the fore shortcomings of the application of these fee structures in practice. That certainly is not in dispute. They, however, have not attacked the principle to the same degree of adversariality as they have condemned the practice.
Let’s take a much deeper look.
Why Performance-Based Fees?
Performance-based fees can be defined as additional fees above a low base fee that reward an investment manager for outperforming a predefined benchmark. Like fixed fees, performance fees are paid as a percentage of the assets under management, with the percentage determined as a share of the outperformance generated. They are designed to reward an active manager’s skill in generating outperformance as well as to ensure alignment of interests of investment managers with those of their clients.
Performance fees motivate the manager to generate maximum returns. They can act as a key determinant of the difference between an asset manager striving for superior outperformance as opposed to being comfortable with benchmark-like average performance. With performance fee arrangements, the relationship between performance and a manager’s revenue is a lot more direct and immediate.
Performance fees discourage asset gathering, but instead motivate the manager to manage his investment capacity. Where a manager is charging fixed-rate fees for his skill, there is obvious incentive to increase assets under management to increase fee income. But increased assets under management are not always in the investors’ best interests, especially when investment ideas are scarce, or market liquidity is constrained. This is especially so with our local stock market that is neither that deep nor broad.
Furthermore, performance fees allow investors to pay for investment skill when they can most afford it. In tough times, when returns are low or even negative and charges matter most, it is unlikely that investors would incur significant performance-related fees and in fact may, in some cases, actually pay less in management fees for underperformance. When times are good and returns are more substantial, however, investors are asked to pay what should be a relatively small slice of their total gains as a bonus to reward the skill of the investment management that has delivered those returns in the first place.
Performance fees allow investors to reward performing managers and “punish” under-performing managers. They also reduce aggregate industry fees because only managers that outperform get paid the aggregate additional fee. A manager’s willingness to accept performance fee arrangements is also a good measure of his confidence that he will out-perform the benchmark against which his performance is measured.
No Above-Reproach Panacea Though
The ability of performance-based fees to align investor preferences for risk and return with managers’ incentives has been challenged quite a bit lately. In the case where an investor is risk averse, a sudden switch to a standard performance-based fee does not, in and of itself, automatically and immediately, align the manager’s incentives with the members’ preferences since the standard fee rewards higher returns with no reference to volatility or risk.
There is also the issue of asymmetry – the fee is positive only and can create an option-like transfer of expected value from the investor to the manager. For instance, the manager can invest in a promising, but risky, strategy. If the strategy works, both investor and manager benefit. If the strategy fails, however, the investor loses his capital while the manager loses only fees. This asymmetry may provide an incentive for the manager to add to the risk of the portfolio by “leveraging up” the underlying portfolio positions.
There is also the question around who designs the performance fee models? These models are generally structured by the asset managers themselves and are only offered when a manager is confident that the arrangement will result in higher fees than the alternative fixed-fee rate.
A more complicated issue pertains to asset manager behaving in ways that are not optimal for the investor. First, the manager is motivated to take excessive risk when “behind” part-way through the year, having no chance to earn a performance fee except by making risky investments. Second, the manager may be tempted to “shut down” and invest in riskless strategies when “ahead” part-way through the year, so he can lock in the performance fee.
If performance fees are calculated over a period which is too short, then fees could be levied on performance that was not a result of the manager’s efforts, but from random short-term market movements. Furthermore, the investor runs the risk of a “heads I win, tails you lose” situation when performance fees are collected immediately after outperformance, but not given back in periods of underperformance. Still further, fees calculated over “rolling” periods have the drawback that recent investors could be charged fees for returns that accrued to the portfolio in the past, but not to their investment.
Of course, the list would not be complete without mentioning the real “joker” in the game – and that is, performance fees can still be charged even if portfolios deliver negative performance. For instance, if a manager uses the ZSE All Share Index as its benchmark and the index falls 20%, the portfolio will still have beaten the benchmark and can still charge performance fees if it only falls 19%. This means that investors can be paying performance fees, even though they are actually worse off. That brings into question the assertion from investment managers that performance fees ensure that investors only pay “when they can afford to”.
Performance fees, where they have been more popular, have also recently become topical among regulators and industry bodies with some regulators highlighting such fees as an area for attention. This is largely as a result, in most instances, of them being poorly designed and too complex for clients to understand.
Limited disclosure and a lack of transparency have also been highlighted among the major pitfalls of these fee models.
The Solution is in the Design
We will be the first ones to admit, fair and effective implementation of performance-based fees is quite challenging. But, we should not despair and throw the baby away with the bath water. There are ways to fix the bulk of the issues highlighted here.
By co-designing the performance-based fee model with their asset managers, trustees, guided by their investment consultants, can ensure that they settle for a fair and equitable performance-based fee structure.
The starting point is establishing what the base fee should be. This must be much lower than the fixed fee the manager would have charged on a flat-fee model. That then is immediately followed with a focus on what the manager’s proposed participation rate is once an agreed upon hurdle rate has been beaten. The simple rule of thumb is that the base fee and the applicable participation rate should be such that there is a 50:50 chance that the manager’s aggregate fees from a performance-based fee charging model will be above or below a given, and acceptable, fixed fee.
With that agreed on, the real craftsmanship of performance-based fee designing begins. This, of course, assumes that an appropriate benchmark has already been agreed on too.
Among the critical issues of this design work is addressing the thorny issue of the asymmetry of fees. The fee structure should be such that the manager participates both in the upside as well as in the downside – that is, not only earns a performance bonus when he outperforms, but also gives back to the portfolio an equitable fee in the year he underperforms. Mechanisms to address this would include providing a clear position on when any performance bonuses accrued are actually crystallised.
Added to that, a high watermark provision ensures that the manager does not get remunerated twice for the same outperformance as they recover from the bottom following a period of losses.
Trustees will also need to ask how frequently the performance is calculated. Investing is a long-term commitment and investment skill, as opposed to luck, can only be properly determined over fairly long periods of time – three years being considered an acceptable minimum. Performance, annualized over such a period or longer ensures outperformance is tempered and trustees are less likely to reward lucky outperformance or too easily forgive under-performance.
Other focus areas include establishing whether the performance fee is calculated before or after the base fee has been deducted, and whether a cap is applicable. A follow up question would be, if a cap is applicable, is it applied to the performance fee in isolation or whether it is applicable to the base fee and the performance fee in aggregate. A cap serves to ensure that an asset manager will not simply pursue performance fees “at all costs”. They are also a good way of avoiding the rewarding of lucky over-sized out-performance.
Where a manager proposes a performance-based fee, it is good practice for trustees to ask if there is a flat-fee alternative. If not from the same manager, then from other managers offering comparable portfolios. Trustees need to determine a breakeven point, or “sweet spot”, at which they would be indifferent with either a flat fixed fee or a performance-based fee. Once they have determined this, it then becomes a question of how exactly they would want to ensure that the asset manager “sweats” for his fees.
Co-designing the fee structure with their asset managers automatically addresses the issue of transparency too as trustees would have been a party to designing the model based on which they then remunerate the manager. This too will ensure that trustees only settle for a model that is simple and understandable to both themselves as well as their members.
Conclusion
Performance-based fee structures remain one of the most powerful tools to address comprehensively investor-manager agency problems. They seek to compensate an active investment manager only when he has genuinely added value to an investor’s portfolio. That the practice has been flawed does not make the principle wrong.
It is the practice instead that simply needs to change – and all that it requires is for those on either side of the capital-allocation fence to come together and design models that are fair and equitable to both the investment managers and the pension funds.