The pressure active management is feeling to lower fees to stem the outflow of assets is not news. I would like to present some options for how managers can adjust their fee structure. The goal of each option is to move the investment management industry away from a business and towards a profession (the desire of Charlie Ellis) and to better align the incentives of clients and managers. If a manager truly possesses skill to pick stocks that outperform in the long run, than she should be well compensated for that service. And the client should be happy to pay that fee. The goal is not to get rich by collecting fees from your clients, it’s to provide a service to your clients that they find valuable and satisfactory.
Michael Mauboussin and the pseudonymous blogger Jesse Livermore have both discussed the excess level of active management in the market today. Michael Mauboussin has addressed the issue with the paradox of skill model. The linked paper is more than worthy of your time but the general idea is that while the general skill of investing has increased over several decades, the relative skill amongst active managers is actually decreasing. Most active managers are now highly educated, highly incentivized, have access to all available public information at their fingertips, and are working with the best technology. Michael Mauboussin also points out that as mom and pop investors leave active management for passive investing, this increases competition due the ratio of “amateur” investors to “professional” investors shrinking.
Chart source Michael Mauboussin’s “Looking for the Easy Game in Bonds”
Jesse Livermore has tried to quantify the amount of active management needed in the market and the value active management adds to the market. Again, it is more than worth your time to read both pieces of research but he finds that the only real value active management adds is liquidity. The number of managers needed to provide that liquidity is much smaller than the number of managers today. Price discovery and allocation of capital to corporations are the other two services active management provides, but those can be done at a minuscule cost.
With our backdrop set, it’s obvious that the 1% fee mutual fund managers charge is unsustainable and an unreasonable fee for most to charge. Beyond the poor performance by most managers, the 1% fee structure (1PFS) creates a poor incentive structure for both the client and the manager.
Under the 1PFS, a manager is more incentivized to grow her AUM rather than outperform her index. At the early stages of a manager’s career, she will be incentivized to beat the market because she will need to develop a top tier track record to attract potential clients. But after reaching a certain threshold, the manager will be more inclined to grow her AUM rather than improve performance because her compensation will be determined more by her AUM rather than her performance. As her AUM continues to grow, her available investible universe will begin to shrink and her ability to invest in smaller, less liquid stocks becomes more difficult (see “Mutual Fund Flows and Performance in Rational Markets” for a longer discussion on this topic). The allure of closet indexing will become a more attractive style as career risk becomes a bigger factor with more assets to manage. The 1PFS creates an assets over alpha rather than an alpha over assets mindset.
A New Hurdle Rate
Because of the wealth that has been created under the 1PFS and the inertia of it within the industry, the clients must first be able to recognize the amount of active management in the funds they are invested in. The formula for this exercise was created by Martijn Cremers in the paper “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity”. The idea behind the formula is show clients how much they are paying for actual active management with a manager, given the option to also invested in a low-cost index fund the manager is benchmarked against. The formula has two steps. First, there is the calculation of Active Share:
Where N is the total number of stocks that is included in the fund
D[Wfund,i>0] is an indicator variable equal to 1 for all positions where the fund is positive (i.e., not short) and is zero otherwise, where we also assume that all benchmark weights are non-negative
The second formula is Active Fee:
The active fee formula shows a client how much active management they are truly paying for. It also acts as a hurdle rate for managers to justify their own fee versus the index fund that mimics their benchmark.
Active Fee should be on every manager’s Morngingstar report next to the fund’s performance figures.
Now that clients have complete information about what they are paying for, it’s time to change the fee structure so that incentives are aligned.
Hedge Fund Lite
The first step is to create a structure that allows the manager to enjoy the gains of outperformance with their clients and suffer the consequences of underperforming. The obvious answer is to institute a hedge fund type fee structure with a lower AUM fee where the client pays a minimal amount every year to partially cover the expenses of the running the business and bringing them on as a client. This could range anywhere from the fee for the managers benchmark ETF to 50 bps. Then the next step would be to create an incentive fee where the manager keeps a certain percentage of the investment gains earned in excess of the benchmark’s return. This structure would better align client/manager incentives.
Fixed Fee
A variation of the Hedge Fund Lite model could be to institute a fixed fee for the client instead of an AUM fee and then add an incentive fee. This structure almost completely removes the assets over alpha mindset but would probably remove small mom and pop investors from investing in the managers as the initial fee would probably have to be fairly high, at least several thousand dollars, if not more.
Active Fee Hurdle
Another option could be to utilize the active fee formula. Since the active fee formula acts also as a hurdle rate for managers to justify their cost; if a manager fails to clear that hurdle, she would be forced to refund her clients a portion of the fee collected. This refund would reflect the difference in fees between the underperformance of the hurdle rate and the index fund fee. For example, if a manger’s hurdle rate is 100 bps and performance is 50 bps, then the manager would have to refund the client half of her fee. If the manager outperforms the hurdle rate, then she would get to keep a percentage of that outperformance.
Below are charts that play out two scenarios, one where the manager underperforms the market over 30 years, and the other the manager outperforms the market. In both scenarios, the client’s outcome under the Active Fee Hurdle structure is better than the 1% AUM Fee structure.
Link to spreadsheet at end of post
The refund period would have to be staggered or allowed to be executed over a few weeks so that the fund managers that underperform aren’t selling stocks at the same time to payback investors.
If instituting this fee structure, the duration that performance is measured should change as well. Instead of measuring performance on a one year time period, the performance should be measured on one, three, and five year period. Hypothetically, the five year performance period would have a 50% weight, three year period a 30% weight, and the one year period a 20% weight. The issue this presents is that most investors don’t own mutual funds or active ETFs for five years, let alone one year. While an incomplete answer for now, a predetermined weight structure would have to be set up in advance for multiple scenarios.
Zweig Incentive
A third option that could be instituted on its own but is probably better combined with the Active Fee Hurdle is what I call the Zweig Incentive. Named after the Wall Street Journal columnist, The Zweig Incentive rewards clients for sticking with a manager for the long term. If a client stays with a manger for at least three years, then the client’s AUM fee is discounted. The article cites one hedge fund that reduces fees for clients over a three, five, or seven year commitment period. Another wealth management firm, Ritholtz Wealth Management, instituted this fee structure for its clients.
The client isn’t the only person that benefits under this fee structure. The manager can make truly long-term investment decisions knowing that clients are more willing to stick with her over several years. This in turn benefits the client because investments are more likely to succeed over then long-term.
Pricing Power
I think it is also important to think about the pricing power of the asset management industry. Because of the ease of access to public market beta and the low cost for that access thanks to Jack Bogle, fees for active management are naturally going to decrease, especially for closet indexers and those unable to produce alpha. Hedge funds, while still providing exposure to public equity markets beta, can still charge a high fee because they are treated more like pieces of fine art than a portion of an individual’s asset allocation (all credit goes to Josh Brown for this idea, he wrote about it and I am unable to find the post. If anyone can find it I will update the link).
Venture Capitalists and private equity can still charge high fees because most individuals can’t invest in Uber’s Series A Round (even if they are lucky enough to know about it) and while most institutions have the capital to invest, they don’t have the capacity to do the research. Vanguard and BlackRock are exploring making these funds more easily accessible, but I doubt that if the two companies are success in their endeavor, the magnitude of the impact will equal to the effect in the public markets.
Variance in returns also has an effect on pricing power. Quoting David Swensen,
“You want to spend your time and energy pursuing the most inefficiently priced asset classes, because there’s an enormous reward for identifying the top quartile venture capitalists and almost no reward for being the top quartile of the high-quality bond universe.”[1]
Source: Michael Mauboussin: “Who is On the Other Side?”
Building a Profession
The objective of a new fee structure is to return the
investment management industry back into a profession. Skilled managers should
always be well compensated for their work; but the ability for unskilled
managers to get rich at the expense of their clients is part of the reason
active management is seeing a decline in AUM. If the fee structure is changed
so that both the client and the manager are incentivized to make decisions that
optimize for the long-term, than both should benefit.
https://docs.google.com/spreadsheets/d/1Q30XdWu_TNZB7HKs0e5kF9V2T3JYCN3xxdDlQFg01Sk/edit?usp=sharing
The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.
[1] David Swensen, “Guest Lecture for ECON-252-08: Financial Markets,” Yale University, 2/13/08.
