If asset-based fees are inappropriate for financial planners, then they’re equally inappropriate for investment managers, and other players, argues David Wright.
In a small part of the Australian Securities and Investments Commission’s (ASIC’s) submission to the Parliamentary Joint Inquiry into Financial Products and Services in Australia (“the Ripoll Inquiry”), ASIC said: “Remuneration based on the amount of funds under advice can also create conflicts of interest. Advisers who are remunerated by reference to funds under advice have an interest in selling investment products to their clients and encouraging their clients to borrow to invest.”
While this small piece of ASIC’s submission generated some press coverage at the time, and has direct application to the Storm Financial collapse, and the impact that high levels of gearing had for those clients, the practice of charging asset-based fees extends far beyond financial advisers’ remuneration practices. Fund managers, through their representative body, the Investment and Financial Services Association (IFSA), have agreed to phase out sales commissions on products as part of the Ripoll Inquiry’s focus on adviser remuneration, but have been noticeably silent on the issue of asset-based fee structures. This comes as no surprise, given that most fund managers’ business models are based on this very approach. To be fair then, if there is a focus on the appropriateness of asset-based fees as part of advisers’ remuneration structures, it is appropriate that we ask the same question in relation to fund manager fee structures.
ASIC’s point in its submission to the Ripoll Inquiry could be extrapolated to say: “Fund managers who are remunerated by reference to funds under advice have an interest in accumulating funds under management (FUM), which may not always be in their investors’ interests.” In Zenith’s research of fund managers and funds, this issue is undoubtedly very real, particularly in the management of a number of the domestic asset classes, such as Australian equities (large and small cap) and Australian Real Estate Investment Trusts (A-REITs), where large levels of FUM can constrain the ability of active managers to outperform. In addition, is it appropriate that managers’ remuneration levels (in dollar terms) increase as a result of market appreciation, even if a manager’s performance has tracked – or worse, underperformed – the market?
There aren’t too many other industries that enjoy increased remuneration levels for doing nothing extra – nice work if you can get it! Equally, it should be recognised that fund manager remuneration (in dollar terms) also declines when markets decline. This was no more evident than during the global financial crisis (GFC), where the dramatic and significant decline in investment markets drastically reduced investment management revenue earned from asset-based management fees. This led some managers to reduce costs through redundancies of sales and/or investment personnel. Clearly, this is not a desirable outcome either, and ideally, managers need a remuneration level that allows them to cover the costs of managing their respective funds, irrespective of market movements.
A further question that could be asked of the current manager asset-based fee structures is: “Does it really cost 10 times more to manage and administer an investor who has $1,000,000 invested in a fund as opposed to an investor who has $100,000 invested in the same fund?” Clearly the answer is no. There are significant costs involved in managing a fund, including salaries and bonuses for investment and sales personnel, fund administration fees, custodial fees, fund audit and accounting, licence compliance costs, brokerage, IT & systems costs, professional indemnity insurance and other insurance costs, research fees, and wrap account or master fund platform fees. But there are undoubtedly economies of scale achieved as FUM grows. In theory, managers should be able to determine a fee for managing each investor’s investment, which is a cost recovery plus a profit margin, resulting in a fee for service that does not vary simply due to underlying market movements.
Having said that, many of those providing services to fund managers, including fund administration and custody, also charge asset-based fees. This means that many of the fees associated with administering a fund are variable fees rather than fixed fees, making it virtually impossible to determine a fixed cost for the management of each investor’s investment. Let’s face it, we participate in an industry where the majority of service providers want their slice of an asset-based fee in order to build and grow “scalable” business models, with significant or uncapped potential upside. As a result, this is a fee structure that will be vigorously protected by those participants enjoying the scalability of this remuneration structure. The proliferation of boutique fund managers over the past five-plus years suggests that the assetbased funds management model is an extremely attractive and potentially highly rewarding business model.
Why else would we have seen so many new funds management businesses emerge if the business model wasn’t so attractive? The emergence of this plethora of boutique managers has also resulted in some change to manager fee structures through the introduction of performance fees. This is an attempt to better align the interests of both the manager and investors, and to provide managers with some remuneration upside while capping FUM capacity in an effort to retain the ability to outperform, and protect existing investors’ interests. In theory, this is a noble concept, as it recognises the importance of capping FUM at a level where skilled active management can still produce above-index returns for investors in the fund. In practice, however, there’s been very little, if any, reduction in asset-based management fees, and therefore the performance fee has simply become an additional fee the investor has to bear. Even if there had been a reduction or elimination of asset-based management fees on those funds charging performance fees, the structure of the performance fee needs to be appropriate.
There are many different performance fee structures, including some that in Zenith’s opinion are abhorrent to investors’ interests. Some of the worst examples Zenith has observed include: managers charging a performance fee on returns above 0 per cent; annual reset periods where any underperformance is wiped clean and does not have to be recouped before qualifying for the payment of a performance fee in future; and the lack of a “high-water mark”, combined with frequent payment periods, such that the manager can be paid a performance fee, say on a quarterly basis, for outperforming their benchmark. Given that there are many different components to performance fee structures, including highwater marks, selection of the performance benchmark, payment frequency, the performance period, reset periods, hurdle rates and the magnitude of the performance fee share, it is often impossible for advisers and investors to understand the potential impact (cost) of the performance fee until it’s actually applied.
While the many different components of performance fees can make them overly complex and difficult to assess, the combination of a fairly structured performance fee and a lower or fixedcost management fee, plus a profit margin, could potentially provide a model where skilled managers can operate a sustainable business, with upside for outperformance and alignment of investors’ interests. Although this structure would not provide investors with any more certainty in terms of the actual fees they will pay fund managers (in dollar terms), it at least ensures that they know what the base (or capped) fee for service is, and that the manager is financially incentivised to protect the ability to outperform (by capping FUM) and delivering outperformance to investors.
Ultimately, fee structures are an important mechanism to drive manager behaviour and align it with investors’ interests. While the regulators are focussing on this in relation to adviser remuneration, to ensure advisers behave in the best interests of clients, this provides an ideal opportunity to ensure other industry participants’ remuneration structures are also in the best interests of the end investor.
