Active Fee Management: Notes from the Front Lines

May 30, 2017 |
2 minute read
|

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.

Mark Bennett

Author

Mark Bennett

Managing Director

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. 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. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

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 Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund 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 or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

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Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. 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. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

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 Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund 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 or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.