The Observer


Rethinking Investment Fees - New developments mean it is more important than ever for investors to understand the fees they are paying active managers

by Dan Brocklebank, Orbis Investments

A heated debate

Few debates in the investing world get as heated as fees. Clients howl at being ripped off, while cozy active managers protest under the pressure of lower fee alternatives. The debate pits fee payers against fee takers, passive investors against active ones, and even clients against their own advisors.

Good. Clients should howl. They are being ripped off. As a whole, the investment management industry detracts value from its clients. What other business could thrive for so long while performing so poorly?

We welcome the fee debate, even when it gets heated, and we are hopeful that it will drive improvements and ultimately greater trust in the industry. But one thing about the debate worries us: most of the time, it captures only part of what really matters for investors—the level of the fee.   

Fee risk and the value for money equation

We believe that investors in actively managed funds would benefit from a greater focus on two concepts when it comes to management fees: value for money, and fee risk.

We think that value for money can be determined by looking at the percentage of any outperformance (value added above the benchmark) that the manager takes in fees. If your active manager charges 60bps, is that good value for money? Well, it depends. If they deliver gross outperformance of 100bps, it means they are keeping 60% of the value they created and you are getting 40% of it. If they deliver gross outperformance of 300bps, it means they are keeping just 20% of the value and leaving you with 80%. That’s a big difference. Bottom line: you cannot evaluate a manager’s fee in isolation. You must consider what you have bought for that fee—your extra returns. 

The definition of fee risk is linked. By fee risk, we mean the risk that you, as a client, end up paying a disproportionate share of any outperformance in fees. The most obvious example of fee risk is when a manager is underperforming, but still collecting a fee calculated as a fixed percentage of the assets in the fund. In that case, all of the fee risk is borne by the investors in the fund, not the manager.

Why bother with these concepts? Well, we believe that, as part of a broader assessment of management fees, these concepts can improve a client’s chances of identifying value-adding active managers. Something that is very hard to do.

Picking good active managers is difficult

Part of the difficulty comes from the sheer number of funds available. Active global equity managers seek to identify the most attractive stocks from about 8,000 listings globally. That is certainly no easy task with so many options. However, investors have more than 50,000 funds available to select from!

Faced with such a staggering range of options, investors inevitably look for ways to streamline their decision-making. They look at a fund’s past performance to try and judge the manager’s skill but, as the disclaimer goes, past performance is not an indicator of future results. Over the long term, many funds don’t survive, and great performers in one year may wither in the next. In a 2017 study by The Wall Street Journal, only 14% of funds with a five-star Morningstar performance rating still had the top rating ten years later, and over a fifth of the five-star funds had merged or liquidated.

At the end of the day, active management is a people business. Even the best active managers will underperform for periods of time, so investors need to include qualitative considerations in their assessments. This adds subjectivity, making the selection process even more challenging.

One pushback that we often hear against the rising trend of innovation in fund fees is that it is just making the difficult process of manager research and selection even harder. We believe this argument is misguided and that a deeper understanding of fee structures can actually help this process. That is because, in poker terms, fee structures can be a classic “tell” about a manager and how they will behave. To understand why, it’s worth considering more fully why fees actually matter.

Fees matter—for more than one reason

The obvious reason is that fees reduce a client’s net returns. John Bogle, founder of passive goliath Vanguard, refers to the “tyranny of compounding costs”, where small differences in annual fees compound into staggering differences in final wealth.

He has a point. Over the past 40 years, deducting a 1% annual fee from the returns of the S&P 500 would reduce the ending value of the investment by roughly a third.

But, ultimately what matters is your actual net returns, which are the manager’s returns minus fees. And while fees compound, so too does outperformance. Suppose we took the returns of Berkshire Hathaway over that same 40 year period and applied a 4% annual fee—a fee level, which, if considered in isolation, would certainly look ludicrously high to most fund investors today. However, even after this—entirely hypothetical—4% annual fee, investors in Berkshire Hathaway would still have been more than seven times better off than an investment in the S&P with no fees at all!
Against the tyranny of compounding costs, there is the beauty of compounding outperformance.

Fees matter for more than one reason and focusing solely on their level misses half the picture. Clearly, they reduce your net returns as an investor, but the less obvious reason they matter is that they also influence the behaviour of your manager.

Three fee structures: pros and cons

To understand the behavioural effect of fees on a manager, investors must examine how a fee is structured, not simply how high or low it is. Let’s consider three fee structures: a fixed fee, calculated as a percentage of assets, a performance fee with a high watermark, and a refundable performance fee. 

It’s easy to see why fixed fees have become—by far—the dominant structure in the industry. Fixed fees are easy to understand, easy to compare, stable, and predictable, which is helpful for both managers and clients. But, they are also great for managers in other ways: charging a fixed percentage of a client’s assets every year provides managers with predictable revenue that grows right alongside assets under management.

More worryingly, a fixed fee structure also leads to conflicting priorities. With a fixed fee structure, the temptation for a manager to gather assets is almost irresistible, even if it means growing beyond the manager’s capacity to deliver good performance. Remember, the more money a manager has to deploy, the smaller the investable universe is and the harder it is to maneuverer the portfolio (just imagine turning a speedboat versus a cruise ship!).

Perhaps even more powerful than the temptation to gather assets is the fear of losing assets by underperforming. As a manager, the best way to avoid underperformance is to not deviate too far from the benchmark—to “hug” the index. This gives up any potential for meaningful outperformance, but it also helpfully reduces the risk of spooking clients and triggering redemptions with meaningful underperformance. Keynes’ quip that “it is better for reputation to fail conventionally than to succeed unconventionally” certainly applies to most fund managers, because clients bear 100% of the fee risk under a fixed fee structure—if the manager does poorly, the fees are still collected.

Traditional performance fees with a high watermark solve some of these problems. In these structures, clients pay a base fee plus a share of any outperformance, and if performance subsequently suffers, the manager must recover to the prior peak before earning more performance fees. This performance component greatly reduces the temptation to grow too much, while encouraging the manager to invest actively to try and beat their benchmark.

Unfortunately, this structure also has its fair share of drawbacks. It is essentially a “heads we win, tails you lose” scenario for the manager: the manager shares in performance on the upside, but not on the downside. This creates an incentive to ratchet up risk. Why wouldn’t they? The manager loses nothing if the risky bet doesn’t work, but if the bet delivers a spike in returns, the manager reaps the rewards in terms of a windfall in performance fees. In other words, the manager shares some of the fee risk in good times, but none of it in bad times.

Both fixed and traditional performance fees ultimately do a pretty poor job of aligning the interests of managers with their clients.

Refundable performance fees, although less common, may provide a better alignment of interests. With this fee structure, the manager shares equally in both good and bad performance. Rather than flowing directly to the manager, performance fees flow instead to a fee reserve, where they are available to be refunded should the manager subsequently underperform. In periods of underperformance, fees are refunded to the client from the fee reserve at the same rate that they are earned in periods of outperformance—they are symmetric.

As with traditional performance fees, this structure discourages excessive growth and encourages the manager to invest actively. But unlike high watermark structures, managers with a refundable fee structure share in the upside and the downside. This discourages excessive risk-taking, and helps to ensure that the fee paid is consistent with the value the manager has actually added for the client. In order to receive fees, managers have to generate, and sustain, outperformance over the long term. If they cannot, they will not be in business.

There are downsides however. Of the three structures, the refundable fee model results in the least stable fees, making it more difficult for clients and managers to predict charges. For managers, this requires careful management and attention to their balance sheet, because the fee effectively transfers risk from the client to the manager. That is a challenge, but it can be done. Refundable performance fees and their cousin, fulcrum fees—which scale up and down with performance, but do not include a refund—have been offered by traditional asset managers for more than a decade.   
A more sophisticated debate

With such varied structures—and the varied incentives they create—there remains plenty to debate about fees.
In recent years, the debate has grown more sophisticated. Regulators have shined a harsh light on “index huggers”, while providing space for new types of fee structures. In the UK, the Financial Conduct Authority noted recently that “there is substantial innovation in…[the] development of more symmetrical performance fee models.” Academics have made similar observations. The authors of a 2014
study by Cass Business School in London found that “the most prevalent fee structure currently in the UK market [a fixed fee] is generally the best structure for the manager and the worst for the investor!” They concluded their research with a question: "Since investors would prefer symmetric performance-based fees, why don't more fund managers offer such fees?" (Note: this study was sponsored by our firm, Orbis Investments)

Organizations in the industry seem to have noticed. Japan’s Government Pension Investment Fund, one of the world’s largest investors with >US$1 trillion in assets, has introduced plans to pay active managers primarily based on performance: “without excess returns, their fee must be equal to that of passive managers with the same amount of asset size”. And a recent thought paper from Mercer, a global consulting firm, suggested that active managers should guarantee clients a set level of outperformance, only earning fees when returns exceed the guaranteed level.
Finally, managers are responding to the challenge with at least two global investment firms recently introducing changes to their fee structures that are designed to tie fees more closely to performance. Each produces different levels of fee risk for clients, and different incentives for managers, but we would generally view all of these moves as steps in the right direction.

How can investors make sense of it all?

No matter the fund, an assessment of fee structures should leave investors better informed about the incentives influencing a manager’s decisions. We suggest investors consider incentives in four ways when analysing managers:
  1. Look for fee structures that tie the manager’s interests to yours,
  2. Ask managers about the incentives and risks created by their fee structures,
  3. Ask managers to report on the share of outperformance they’ve taken in fees, and above all,
  4. Focus on maximizing net returns rather than minimizing fees.

With a differentiated assessment of fees and incentives, investors should stand a better chance of finding managers that can deliver good value for money over the long term.

 Dan Brocklebank

Dan Brocklebank is a Director and Head of UK at Orbis Investments—a global investment firm with more than US$35 billion in assets under management. Dan joined Orbis in 2002 as an equity analyst researching energy, industrials and materials sectors. For the last 9 years Dan was responsible for Orbis' team of global sectors analysts based in London. At the same time, he has worked with Orbis' institutional and retail clients to help them understand Orbis' long-term, fundamental and contrarian investment approach. He previously worked at Arthur Andersen. Master of Arts (Honours) in Politics, Philosophy and Economics (Brasenose College, University of Oxford), Chartered Accountant, Chartered Financial Analyst.