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Active Fee Management:
Notes from the Front Lines

May 30, 2017  | by Mark Bennett

Industry Knowledge | Investment Strategy

Few topics get investors’ attention as much as fees.  We wouldn’t be human if we all didn’t want to know, in detail, how much something costs.  In the world of investing, fees are an even more important topic, as they directly relate to your investment performance.  To state the obvious, the more you pay in fees, the less you make in return.  When investing in equity managers, fees paid are critically important because a large component in the “active vs. passive” debate is the ability of active managers to outperform, after fees (emphasis added).  Our approach is to attempt to tilt the odds in our favor, by lowering to the greatest extent possible the fixed fees payable to active managers.  Our recent movement toward performance-based fees have helped in this regard.

Any discussion about fees requires some perspective on the state of the active equity manager universe.  It has been customary in our business for decades to “pay for talent”.  Equity managers with strong historical performance and capacity constraints held a lot of the bargaining power in a fee negotiation, because if one investor didn’t want to pay the fee, another would gladly sign up.  However, investor flows have severely impacted most active equity managers in the past 5-10 years, with some of the biggest contributors being the decline in the defined benefit pension market, the strong preference for passive products, and the proliferation of smart beta investment products.  Exhibit 1 shows the dramatic flows out of active and into passive investments by strategy in the most recent calendar year.

img_table_active-fee-mgmt

The advent of smart beta, not only as a source of fund flows away from active, but also as it relates to the definition of alpha, has substantially changed the bargaining power of buyers of equities during a fee negotiation as well.  Historically speaking, excess return over a benchmark was considered alpha, and investors were willing to pay for positive excess return.  Today, sophisticated statistical techniques can be used to identify “true” alpha (idiosyncratic return not explainable by betas).  True alpha can be defined as excess return after accounting for factor variables such as value, momentum, size, quality, etc.  Each of these factors has  in some form or another been a source of historical active management excess return in the past, and can now be accessed individually through smart beta passive vehicles, such as ETF’s, that operate in direct competition with active managers.  Thinking of these factors as “passively replicated exposures” forces buyers to think of active management, and the associated fees in a different context.  It only makes sense for active management fees to come down to account for the increased competition for investors’ dollars.  Our experience has been that managers are acutely aware of the changing landscape and we have used that shifting bargaining power to our advantage whenever possible.

Over the course of the past several months we have renegotiated a number of fee arrangements with managers, with the goal of decreasing the flat fees paid to give investors a greater chance of winning.  Where appropriate, we have negotiated performance fee arrangements so that our interests are aligned with our managers.  We strive to pay for outperformance, or alpha, and pay nothing, or close to nothing, for market returns, or beta, whichever form it takes.  Under this approach, managers that outperform will be paid an incentive fee, better aligning interests.  In addition, in arrangements where we have minimal or no flat management fees, we pay nothing for underperformance.  In some instances, we have capped the amount of incentive we are willing to pay in order to reward consistency and not compensate for excessive risk taking.

Authors

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Mark Bennett is a member of the Commonfund Asset Management Investment team and is primarily responsible for asset allocation, manager sourcing, due diligence, and investment monitoring for investment portfolios. Prior to joining Commonfund, Mark was an Investment Consultant for defined benefit services at CIGNA Retirement and Investment Services. He was an asset allocation analyst and consultant for CIGNA-Connecticut General Pension Services, Inc. Previously, Mark was a benefit technician for CIGNA Retirement and Investment Services. He received a B.S. from Bryant College and his M.B.A. from the University of Hartford. Mark is a CFA charterholder and is a member of the Hartford Society of Financial Analysts and the CFA Institute.
Mark A. Bennett
Managing Director, CFA

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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.