It’s the skin, stupid

Having completed its landmark study of the UK investment industry, the Financial Conduct Authority issued new rules this month designed to shine a spotlight on the value added by managers. While this is a much-needed development, Japan’s Government Pension Investment Fund (GPIF) has accomplished something arguably more dramatic—and in far less time.

Instead of regulations, GPIF has used its £1trn heft to send a clear message to its active managers: if you want to manage our pensioners’ capital, you will only be paid for outperformance. This is what Nassim Taleb refers to as “skin in the game”. Managers who fail to deliver value for GPIF will now begin to feel real pain by earning no more than a tracker fund’s fee.

GPIF’s decision is particularly noteworthy because it could simply have forced managers to cut their fees or eliminated active managers entirely as many institutions have done. Like the FCA, it has focused on a more robust solution that recognises that we can’t all be passive investors and that both active and passive strategies can work together effectively to produce successful outcomes for clients.

The key is getting the incentives right. The FCA said it best in its Asset Management Market Study Interim Report: ‘The prevailing fee model incentivises firms to grow assets under management, which is not necessarily aligned with investors’ best interests.’ GPIF’s approach is even more aggressive in its attack on ad valorem fees, which encourage asset gathering at the expense of performance.

In both the UK and Japan, an inconvenient truth in the fund management industry is that most firms’ profits are determined by their size rather than their performance on behalf of clients. While there are lots of smart and competitive people doing their best to outperform, the practical reality is that it is much simpler and more effective to focus on “not losing clients” and collecting a steady fee rather than risking the golden goose for a few extra percentage points of alpha. Very few investment teams can improve their performance from, say, 2% to 7% alpha per annum—whereas a 5% annual increase in assets under management is a much more feasible target for a good sales and marketing team.

Performance-based fees would seem to be an obvious solution. Surprisingly, they have instead developed a poor reputation. Part of the blame rests with a history of ill-designed fee structures that have been stacked in favour of managers in an asymmetric ‘heads we win, tails you lose’ proposition. In these arrangements, clients pay a base fee plus a share of outperformance, which is really just a type of call option in which the manager stands to gain enormously on the upside yet the client bears nearly all of the downside. Many of these structures are also path-dependent. For example, if a manager produces strong returns in the first few years, and then subsequently underperforms, the client will have paid substantial performance fees in those first years, despite a potentially negative cumulative total return over the full investment period.

In a perfect world, a client would pay nothing until the end of their investment horizon and then simply pay the manager a fee proportional to the value added. But in real life, managers still have to keep the lights on and retain their investment talent. Fortunately, there is a practical solution. It’s possible to design refundable performance fees in which 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 reserve at the same rate that they are earned. The manager is only able to draw from the fee reserve once it has reached a designated proportion of the client’s assets. Importantly, this is not a “blue sky” suggestion—at Orbis we have offered refundable fees to our institutional clients since 2004.

In our experience, the symmetrical nature of a refundable performance fee substantially mitigates the major flaws of traditional fee structures. Refundable fees ensure that incentives are focused on delivering superior long-term returns, while also discouraging excessive risk-taking that comes with an asymmetric payoff. We have also found that it helps to smooth out client returns, which can help reduce the behaviour penalty during inevitable periods of underperformance.

Of course, we don’t claim to have invented the perfect solution. Hopefully GPIF’s move will be a call to action for more managers to introduce well-designed performance-based fee structures. Some of these will be more effective than others. In all cases, investors would be wise to heed Taleb’s advice: “Do not pay attention to what people say, only what they do, and to how much of their necks they are putting on the line.”

 

Dan Brocklebank is head of UK, Orbis Investments

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