Recent moves by a handful of fund managers to offer performance-based fees are a welcome development. Hopefully, others will embrace the trend. But the new fee structures need to be designed to ensure portfolio managers have enough skin in the game to be truly in sync with the interests of those whose money they steward.
Fidelity International (the international arm of Fidelity Investments until becoming independent of its U.S. parent in 1980) provided a diagram of its new fee structure this week, without specifying actual levies. As I suggested earlier this week, I would go further. Here's how.
At some level of underperformance versus the benchmark, the fund manager should earn nothing in fees. While it makes sense for the baseline management fee to be higher than a comparable passive product fee -- after all, there should be some compensation for the increased cost involved in an actively managed product -- any underperformance should lead to a fee reduction that rapidly punishes the active fund relative to a passive alternative.
The following chart is based on one Fidelity published earlier this week; I've augmented it to show both where active fund fees should be in relation to passive fees, and to remove the floor Fidelity suggests for underperformance.
AllianceBernstein Holding LP already offers U.S. products with performance fees and is mulling European launches, as is Allianz SE's Global Investors unit. Orbis Investments, which manages about 25 billion pounds ($33 billion), has offered funds to U.K. retail investors since 2014 that provide refunds if a manager beats the benchmark only to subsequently lapse into underperformance.
As welcome as the shift to tying what investors pay to how well a manager performs, it's not a new idea. Three years ago, a research paper by the Cass Business School in London examined three different fee models. The study differentiated between fixed fees, asymmetric performance fees that have a fixed and performance element, and symmetric fees dictated by performance alone.
The study argued that charging a fixed fee "encourages managers to grow their asset base beyond the level that is consistent with sustaining `superior returns.'" Bad performance, meanwhile, is less likely to be punished by investors withdrawing funds.
The asymmetric performance fees charged by many hedge funds, meantime, could be described as `heads we win, and tails you lose,'" the Cass study argues. The so-called "two-and-twenty" model, for example, charges 20 percent of positive returns, and 2 percent of assets under management. So no matter how badly a hedge fund performs, it's guaranteed at least 2 percent in levies.
The conclusion of the paper was quite stark:
Investors, in the majority of cases, would prefer symmetric fee structures. Only when an investor is certain (before investing) that an investment manager is very skilled and takes a lot of risk would investors prefer fixed fees. The theoretical literature is therefore largely supportive of symmetric fee structures as a way of aligning manager and investor interests.
It's worth noting that the decision to offer a different choice of fee structure isn't just driven by a Darwinistic desire to fend off the flow of money fleeing to low-cost tracking funds. Increased scrutiny by regulators, including the Financial Conduct Authority which is the U.K. industry overseer, is also spurring reform.
Here's what Fidelity International said this week in the press release announcing its decision to introduce active equity funds with fees tied to whether those funds outpace their benchmarks (emphasis mine):
These changes will more closely align the performance of our business with the performance of our clients’ portfolios and deliver what we believe clients and regulators are looking for.
The investment management industry has feasted for too long on opaque fees and hidden levies. Explicitly calibrating management income with performance would expose poor performers to some Schumpeterian creative destruction.
By pledging a zero management charge for active portfolio managers whose returns are far below what a low-cost tracker fund can achieve, fund managers can regain the faith of investors and regulators that the interests of principals and agents in the socially essential business of providing for retirement are truly aligned.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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