Investment Manager Fees:
Out of Sight, Out of Mind

May 22, 2019  | by John Delano, Kristofer Kwait

Industry Knowledge

One of the most pressing questions facing fiduciaries is that of investment management fees. We think it is a healthy and necessary discussion, as even small fees can have a big impact on performance and portfolio values, especially given the perpetual time horizon of most nonprofits. But, if you believe as we do, that alpha exists and is worth pursuing, then the the next question is; what is it worth? In our view, investors should focus their attention on value, meaning net of fee returns, rather than simply looking for the lowest gross fees.

It is informative to look at hedge funds as we consider what fees we should be paying to a manager in return for excess performance. Exhibit A shows the fee schedules of all managers in the HFRI hedge fund universe. Each blue dot represents an individual manager plotted by their management and performance fees. One thing you can see immediately is that the blue dots are clustered into regular squares even though there are thousands of individual fee schedules. This tells us that most managers charge the same or similar fees, such as the commonly known 2 percent management fee and 20 percent performance fee (aka, 2 and 20). These squares also tell us something about investor behavior – it is a clear example of what we call “fee herding” – meaning this marketplace of buyers and sellers is inefficiently priced. Imagine if insurance companies charged the exact same fee for flood insurance on every house in America, regardless of location.

CH_01_Exhibit A_Why are Investment Fees Round Numbers Anyway

How do we determine the fair price for a manager?

To assess the value of a manager, we start by understanding their returns – specifically, how closely we can replicate the manager’s strategy using inexpensive, easily accessible, liquid factor exposures. This step is like breaking a manager down into the sum of its parts. The building blocks that we use for this can include ETFs or simple equity market trackers, “smart beta” products, or other alternative sources from different beta providers. What these instruments all have in common is that they do not come with any performance fees. Exhibit B shows some of the many factor exposures that are available today.

CH_02_Exhibit B_Sourcing Returns is Cheaper and Easier Today

Starting with this analysis forms the basis for a clearer picture of the value that the manager represents, in comparison to the cost savings that can potentially be realized through a factor portfolio. In many cases, this analysis shows that a manager is far from the “low-cost” producer for their specific strategy.

For example, Exhibit C shows the growth of a dollar invested in a large, well-known credit and event-driven hedge fund (manager A) alongside a factor-based replication portfolio constructed using four factors/sources of return: credit, merger arbitrage, equity market, and equities commonly held by hedge funds. The manager produced gross of fee returns of 7.4 percent but, net returns after two percent management fee and 20 percent performance fee are reduced to 4.1 percent. Meanwhile, the factor replication portfolio net of fee return is 5.6 percent. If bread costs $30 a loaf but we can buy flour and water and make it for less, the cost of the bread should come down. In this case, if we can replicate this manager that charges 2 percent management fee and 20 percent performance fee for just 39 basis points, then there may be a discrepancy in their value proposition.

CH_03_Exhibit C_What is Fair Market Price for a Mgrs Rtn - Replicating Mgrs Rtn Factors

Calculating the fee indifference curve

This analysis may conclude that a manager is overpriced or appropriately priced. In any case, it is a starting point to further evaluate how different combinations of management and performance fees affect the returns the manager ultimately delivers, and how we can evaluate those trade-offs.

Exhibit D quantifies this trade-off: each blue dot represents the result when the manager’s gross returns are subjected to many different fee schedules, varying from 0 to 2.5 percent management fee and from 0 to 25 percent performance fee. In this example, a factor portfolio that comes close to replicating the manager’s strategy and would therefore play a comparable role in a portfolio demonstrates a hypothetical return of 5.6 percent. That’s the point, shown in red, at which all things equal we are “indifferent” to the fees.

All the other potential combinations of management and performance fees that result in that same net return of 5.6 percent are on the red line–we call this the “fee indifference curve”. The fee combinations below this red line are deemed expensive and those above the line are competitive.

CH_04_Exhibit D_What is Fair Market Price for a Mgrs Rtn - Single Mgr - Fee impact on returns

While the manager’s return gross of fees cannot be entirely matched by a factor portfolio, the replicating portfolio does provide a frame of reference for determining how much we can accept in either management, performance fees, or both, allowing us to pay the right price for the manager’s “loaf of bread.”

This is a critical part of our manager evaluation and due diligence at Commonfund because years of running this analysis have shown us that most managers are not competitive – allowing us to focus on only those managers that we deem to be delivering a superior value.

In part two of this blog series we will delve into fee alignment – our approach to ensuring that we not only have secured a good value but that we are also properly incentivizing the investment manager while maximizing net returns for the investor. Sign up for the Commonfund Insights Blog to assure you get this next installment delivered directly to your inbox.

Authors

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John Delano is Head of Research and Analytics. John is responsible for quantitative analysis of our funds and managers. Prior to joining Commonfund, John was a consultant in Global Public Opinion Research at Altria Corporate Services and a research assistant at Columbia University′s Institute of Social and Economic Research and Policy. Prior to that, he worked as a media buyer at Horizon Media, using statistical analysis to forecast audience deliveries for television commercials. John has a B.A. in Political Science from the University of Chicago and an M.A. in Quantitative Methods in the Social Sciences from Columbia University. He also holds the Certificate in Quantitative Finance (CQF).
John Delano
Managing Director, Head of Research and Analytics
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Kristofer Kwait is co-Deputy Chief Investment Officer, and Head of Investments responsible for leading the marketable equities, fixed income, hedge funds and real assets investment teams as well as analytics. Prior to his current role, Kris was head of the Hedge Fund Strategies Group. Previously, he served as head of hedge fund research with responsibility for overseeing the design and implementation of proprietary models for manager selection, portfolio construction, and risk management. Before joining Commonfund, Kris was a proprietary trader at both Andover L.L.C. and A.B. Watley, where he managed relative value equity strategies. Prior to his experiences as a trader, he was a stockbroker at Smith Barney. Kris attended pre-college at Juilliard School of Music, has a B.S. from Purdue University and an M.B.A. from the Yale School of Management.
Kristofer Kwait
co-Deputy CIO and Head of Investments

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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.