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

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. 

 Of course, no fee structure – no matter how well designed – can make one a better investor.

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.

As appealing as this may be, it is uncommon because these approaches introduce business risk for an investment firm. When fees are 0 per cent, a manager who delivers performance in line with the index won’t stay in business long. But that’s the point. What better way could there be to focus the organisation’s attention on delivering sustainable value for clients? 

Such a manager would have very little reason to prioritise the gathering of assets and an extremely powerful incentive to focus on their highest-conviction investment ideas. Business risk would remain a challenge, but investment managers are meant to be expert at analysing business models and so should be able to manage this with prudent capital reserves and performance-based variable remuneration structures. After all, investment management firms have minimal capital expenditure requirements to budget for. 

Of course, no fee structure – no matter how well designed – can make one a better investor. Active management is a zero-sum game and in order to add real value over the long term, managers must be able to exploit market inefficiencies and capitalise on the mistakes of others. Unless your active manager can make a convincing argument that they have the philosophy, process and people in place to do this over the full investment cycle, you really are likely to be much better off changing to a different manager, or even to an index fund. 

Dan Brocklebank is a director of Orbis Access and chairman of Orbis’ UK executive committee