Fresh thinking is needed on fund management fees.
The Financial Conduct Authority’s (FCA's) final report on the Asset Management Market Study, published in June this year, was a watershed moment for the UK asset management industry.
Some participants predictably complained that the regulator came down too hard, while others said it wasn’t tough enough. At Orbis we believe both sides are missing the point.
Too often the debate has been characterised as the “FCA versus the industry”, but we think a far more constructive approach would be appropriate for all parties to embrace the opportunity for improvement on behalf of investors. And few areas of the industry are in greater need of improvement than fee structures.
The trouble with flat fees
In the overwhelming majority of cases, fees are structured on an ad valorem basis: a flat percentage of assets under management.
Besides being straightforward to administer from an operational perspective, flat fees also provide managers with a fairly predictable stream of cash flows to keep the lights on and to attract talented people.
The only problem is that the amount of money an asset management firm earns is almost completely detached from the investment performance that clients receive.
The FCA made it clear on page 93 of its Interim Report: “The prevailing fee model incentivises firms to grow assets under management, which is not necessarily aligned with investors’ best interests.” Long before the FCA’s investigation, Vanguard founder Jack Bogle derisively referred to flat fees as the “croupier’s take”.
Mr Bogle’s casino analogy is a bit harsh because there are many intelligent, competitive and hardworking people in the industry, and the vast majority have nothing but the best intentions.
Even so, these well-meaning individual efforts are rarely enough to overcome the powerful commercial incentives that come with flat fees.
The unfortunate reality is that it is almost always easier for a business to increase assets under management by deploying additional resources in sales and marketing rather than by seeking superior investment performance.
An incremental 5 per cent a year in long-term asset growth is an easy hurdle for a good sales team, but the same amount of additional outperformance is almost insurmountable for even the best investment decision-makers.
There is also human nature. For firms and individuals alike, there can often be a survival instinct which makes it imperative to avoid losing one’s business or job by being different and wrong.
As the early 20th Century's leading economist John Maynard Keynes wrote: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
The most extreme outcome is closet tracking, which offers the worst of both worlds—a high price for an undifferentiated product. In almost any other industry, competition would quickly eliminate such an inferior product, yet as the FCA rightly points out, it remains all too common in fund management.