Fees are frequently overemphasized by Investment Committees when evaluating an Outsourced Chief Investment Officer (“OCIO”). Committees often believe that fees are a quantifiable and tangible way to compare managers, when in fact, fees between managers are incredibly hard to compare. Due to a lack of transparency and consistency across the industry, the “sticker price” for an investment manager is often misleading, resulting in many investors not knowing what their actual “all in” costs are, much less if they are paying a reasonable rate for each underlying component.
Most investors know their total cost can vary widely based on the total amount invested, asset allocation, performance, allocation within selected funds, and ‘extras’ such as reporting on outside managers and a broad range of other costs and service choice options. It’s less known that while the underlying components of costs are consistent, the way each of those components is reported is frustratingly inconsistent among managers. Management fees may show up in RFPs and presentations as bundled, a la carte/unbundled, layered, or flat—or they may not show up at all! Embedded and hidden fees are common and by design, easily overlooked.
It is essential to understand how managers package and present their fees. Hidden fees negatively impact performance and can create the potential fee-related conflicts of interest.
Here are five eye-openers regarding OCIO fees:1. Passive Fund Management Doesn’t Always Mean Lower Cost
Typically, active managers offer passive funds, and passive managers offer active funds. Shockingly, passive funds offered by traditionally passive managers are not necessarily priced less than similar funds offered by their active manager competitors. Bottom line: when implementing a portfolio with both active and passive funds, the fee difference between partnering with an active manager vs. a passive manager is often negligible.
2. Look for Hidden Layers in Fees
The “advisory fee” is the amount you are most often quoted. It is the direct fee paid to your OCIO provider for their advice, oversight, diligence, manager selection and implementation on your behalf. It may also be called a consulting fee, a retainer fee or a wrap fee. Typically, the advisory fee is set as a percentage of your total AUM. In most instances, the higher the level of discretion a manager retains, the higher the fee. However, the advisory fee may really be a relatively modest portion of your total cost! Look out for managers that point you to their advisory fee, without providing full transparency on additional indirect fees, such as:
- Underlying investment manager fees, performance fees, fund-of-fund fees
- Transaction fees for redemption, trading, custody and securities lending
- Fund servicing fees for legal, audit and administration
- Special fees for reporting on outside assets, customized reporting and client service models
Hidden fees are dangerous because they falsely inflate historical performance and in doing so, increase the burden of due diligence on investors.3. “No Cost” Solutions Always Have a Catch
The “No Cost” approach is your formal invitation to play the game of “Find the Fees”. They are buried somewhere. The first place to look is at the fund level fees. If the manager is using proprietary funds, there is often a fee baked in which goes directly to the management company. Worse, it is not unheard of for an OCIO or an allocator to receive a kick-back for including a particular manager’s fund in its allocation model or on its platform. These incentives can be monetary in the form of a rebate, or a soft dollar arrangement which provides free services or benefits to the OCIO. Further, no cost or very low-cost solutions can create conflicts of interest and increase your diligence burden.4. Bundled Fees Require Transparency
Bundled or flat fees sound enticingly simple—but without complete transparency, they can turn into a bundle of trouble. How much of the fee is going directly to the OCIO? How much is allocated to indirect managers and services? Bundling fees has the potential to create a conflict of interest if the OCIO favors lower-cost managers to increase their own margin over higher-cost managers who may provide you with better performance.
5. Watch Out for the Redemption Fee Trap
Starting a new OCIO partnership brings optimists and pessimists together over a clean slate. The group focuses on the next steps of onboarding, feeling this will be a smoother relationship with better long-term potential than the one they left. Rarely is anyone thinking the Investment Committee may have to fire this new manager at some point down the road. Unfortunately, some managers take advantage of this honeymoon period and fail to clearly point out their stiff redemption, or back-end fee clause. These fees can be onerous and can significantly reduce your historical performance. Attempting to avoid this fee hit, Investment Committees sometimes choose to stay with the underperforming manager for too long. Redemption fees inevitably create an unfair lose-lose situation for the investor.
So, while fees are part of your manager evaluation process, they should not be the deciding factor. Your future success will be strongly influenced by a potential manager’s experience in working with similar clients, the manager’s willingness to gain a deep understanding of your organization’s operating environment, along with their ability to partner with your constituents and to evolve with you and the markets over time. A high-quality manager provides meaningful guidance, prepares your Investment Committee for market events, and helps improve governance. In the long run, these skills outweigh the line-item fee.
Without standardization in reporting fees, Investment Committees are forced to dig deep to uncover multiple layers of fees if they are to know their total cost of investment management. Only when they know the total cost can a manager’s performance be measured fairly. If you’re considering issuing an RFP or changing OCIO providers, we have a number of additional blogs that you may find helpful.
Commonfund is dedicated to promoting transparency in investment management and governance throughout the industry. We believe it is essential to provide full transparency on both fees and performance, arming investors with the data they need to perform their due diligence, analyze, and evaluate our results. As always, we welcome the opportunity to connect with you on this topic or any others that may be helpful.