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Fee scrutiny is key as the market cycle turns

31 March 2019

Fees have become a thorny issue for the asset management industry in recent years, says Dan Brocklebank, UK director of Orbis Investments. He looks at the different fee structures and the potential affect on investor returns.

Low-cost tracker funds have flooded the market, putting active managers under increasing scrutiny to demonstrate their value. Regulators expect firms to justify their fees. Despite this, many active fund managers still charge a fixed fee, regardless of how they perform, while others reward managers for beating inappropriately low benchmarks. Often, over complex fee structures baffle investors and disguise the true costs.

Time to rethink

Periods of strong market performance can cast some average fund managers in a very favourable light. And during such periods few clients think about the impact of investment management fees and charges, or consider whether or not they’re getting value for their money.

In fact, the Financial Conduct Authority’s (FCA) recent Asset Management Market Study suggests that when returns are positive, clients may not even pay very close attention to poor returns, as long as they’re poor positive returns.

But things may be about to change. The MSCI World Index delivered an annualised 12% return in the ten years to 31 January 2019. Should the market cycle turn, rather than just picking funds based on historic performance, advisers will increasingly be expected to also lessen the impact of costs and charges through choosing funds that offer better value for money. 

Value beats price

It’s tempting to try and solve the problem by looking at cost in isolation and thinking lower must mean better. Unfortunately this isn’t always the case – cheap funds can perform poorly too. Rather than just looking at the fee level, the fee structure is important in order to understand the likely impact over time and identify the funds that offer real value, and those that don’t.

Aside from the pure impact on return, the fee structure can also influence the fund manager’s behaviour:

  • A fixed percentage of the size of the fund

Flat fees offer advisers an easy-to-compare total, but the FCA’s Asset Management Market Study warned that this can incentivise fund managers to gather assets, rather than work in the investor’s best interests.

  • A one-way performance fee, typically with a high watermark

This type of fee can effectively motivate managers to aim for higher return. But it can also lead to increased risk-taking, because the manager isn’t penalised for underperformance and gets to keep their performance fee even if returns subsequently crash. With this structure, it may be tempting for the manager to take on extra risk in the hope of a ‘spike’ in returns.

  • A two-way performance fee

A fee that is fully performance-based, and symmetrical, rewards managers for outperformance (and only outperformance) while equally penalising them for underperformance. This type of fee mitigates the potential negative impact of other structures and, by aligning the interests of managers with that of investors, can keep managers focused on sustainable performance.

  • A combination of fixed and performance-based fee

Some fund managers employ a combination of fixed and performance fees, either one-way or two-way. An example of the latter is a structure known as a ‘fulcrum’ fee, where there is a base fee that is increased when there is outperformance and decreased when there is underperformance. A symmetrical fee without a base fee means investors could be charged even less than they would be in a passive alternative for the same performance, and the fee would be further reduced for continued underperformance. But the danger with combined fees, that have a base fee, is that investors could actually end up paying more fees for less reward.

There are surmountable barriers to fairness

The downside of completely symmetrical performance-based fees is largely the lack of predictability. Since future performance can’t be predicted, neither can future fees. In the context of a natural human preference for certainty and regulatory requirements for up-front disclosure, it can be challenging for managers to adopt, and for advisers to explain completely performance-based charging structures.

At Orbis, we’re comfortable being different, and readily accept the challenge. Our fee structure is not only completely performance-based (zero ongoing charges), it’s fully symmetrical – we refund fees when we underperform. While our refundable fee structure is not the one most fund managers would use, we believe that our long-term success depends on delivering real value to clients over time.

If the market cycle comes off its long-term high, advisers will have an increasingly important role to play in recognising value, unpicking opaque fee structures and scrutinising the charges levied on their clients’ investments.

Unfair fee structures are entrenched throughout the industry and simply relating a fee to performance isn’t a panacea: performance fees should be carefully interrogated as not all of them are as fair as they may look. Rather, uncovering real value may require looking to the truly unconventional.

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