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Beware ‘the lower, the better’ mindset; investors should focus on other factors

This article is part of
Investing in Passives - September 2016

Beware ‘the lower, the better’ mindset; investors should focus on other factors

The increasing popularity of passive investment strategies has rightly highlighted the importance of paying more attention to costs and charges.

But too often the mantra seems to be “the lower, the better”. This is too simplistic. Investors would be far better served by focusing on net returns, value for money and whether or not their interests are aligned with those of their investment manager. 

To start with, the industry’s fee structures could desperately use some fresh thinking. The standard model – charging a fixed percentage of assets managed – does a poor job aligning incentives. It’s not because managers who charge fixed fees aren’t trying to do their best for clients. Indeed, there are some who have delivered excellent long-term performance while charging modest fees. 

The real problem is that so-called fixed fees are almost completely detached from value creation because the manager’s incentive is overwhelmingly skewed in favour of asset gathering. Managers effectively collect a toll from their clients regardless of their performance. Any rational, profit-maximising firm that charges fixed fees will almost always find itself prioritising asset growth above all else, particularly if they must answer to external shareholders. Still, clients can receive good value for money provided that the manager’s performance is strong enough. 

It gets a lot more complicated during the inevitable periods of negative performance. Because clients continue to pay the toll, their after-fee experience only gets worse and worse, and the temptation to abandon the manager becomes harder to resist. By the time markets have reached an extreme point, and the manager is salivating at the bargains on offer, the client is likely sick of paying for poor performance and decides to redeem at precisely the worst time. This is the classic ‘behaviour penalty’ and a terrible outcome for both parties.

The solution is to make the incentives more symmetrical by rewarding managers when they deliver value and penalising them when they do not. This takes the behaviour penalty out of the equation to a large extent. Since clients no longer need to pay a toll when performance is poor, they may be more inclined to stick around and benefit from the manager’s decisions over the full performance cycle. 

How would this work in practice? One solution is to refund fees during periods of underperformance; this can be implemented by creating a fee reserve. Rather than flowing directly to the manager, fees can then either be refunded to the client or slowly released to the manager over time. Another solution is to eliminate the base fee altogether so the manager is only paid for outperformance. Assuming that the manager also absorbs other administrative costs, the result – a clean 0 per cent base fee – would offer the best of both worlds: the upside of active investment decisions, but even cheaper than a passive strategy if the manager tracks the index.