Asset Manager Fees

Will investors finally say ‘enough is enough’?

IN  A  RECENT Financial  Analyst  Jour-nal  article  on  “The  future  of  invest-ment   management”,   Gary   Brinson made   the   following   observation:   It’s only  a  matter  of  time  before  investors would  revolt  against  the  current  lev-els  of  asset  management  fees  being charged in the industry.

As  he  pointed  out:  “One  need  only measure the aggregate fees that are paid by  investors  with  the  aggregate value added  by  their  managers  to  see  that something is amiss... because investing is  effectively  a  zero  sum game,  aggre-gate fees for most managers should be associated  with  passive  management. Yet  these  fees  are significantly  larger than fees associated with passive man-agement.  This  illogical  conundrum  will ultimately have to end.”¹Nobody  disputes  that  asset  manag-ers  need  to  be  paid  for  their  services. The  debate,  rather, is over  what  quan-tum is fair.  

How  do  you  approach  the  problem of  ‘fair’?  One  thing  that’s  clear  is  that nobody  has  developed  a  single model approach  to  addressing  the  problem. What  follows  is  a  description  of  three methodologies:   each   has important limitations but, all told, do advance our understanding of the problem.  

The   first   addresses   the   question posed by Brinson. Can the performance contributions  of  asset  managers really justify  the  fees  charged?  The  other  two assessment   approaches   address   the question of “did I pay too much?” given what was delivered.  

The Ennis plausibility model

Let’s   start   by   turning   the   question around.  Just  how  much  skill  does  an asset  manager  have  to  have  to jus-tify  the  kinds  of  fees  currently  being charged?  Richard  Ennis²  provides  an excellent  methodology  for determining that.  

The Ennis plausibility model is pred-icated   on   the   insight   that   the   more expensive  a  product,  the  harder  it is to  deliver  a  product  that  will  satisfy  an investor’s expectations. Fees are only be plausible  if  they  are consistent  with  an acceptable probability of success.

We  then  translated  Ennis’s  research into a tool that’s flexible enough to test the  reasonability  of  fees  with different skills   levels   and   different   acceptable levels of success.  

As can be seen in the table, to main-tain  the same  level  of  investor  suc-cess    probability, the  higher the  fee charged for a prod-uct, the higher the fund manager skill required  to  justify the higher fee.

The results were  a  source  of considerable  con-cern.   A   manager had   to   be   more than     61%     cor-rect  to justify  costs as low  as  30bps (0,3%). Interna-tional  research points out  that only  top  quar-tile   managers exhibit that level  of invest-ment skill. Worse,   a   sur-vey  of  current asset manage-ment   fees   in South     Africa suggests   that 30bps is  actually on the low side, with 45bps being closer to the norm for active management mandates. Move into the unit trust space, where fees can vary between 100 and 150 bps (1% to 1,50%), and the Ennis plausibility model suggests that the manager would need to be 91% correct to merely have a 50/50 chance of adding value. Should a manager’s hit rate be as low as 30% (this actually approximates the skill level of above average active managers) there is only a 21% probability of earning a positive alpha at the 30bps. Now assume your manager skill is above average – or around 30%. The model shows that even at a management fee of 5bps (0,05%), there’s only a 28% chance of the fund manager adding positive alpha. At fees of 3%, there’s 0% probability that there will be positive alpha.

By Ennis’s calculations, most active fund management fees are simply too high given the low probability that managers’ skills are high enough to deliver positive alpha.

Did I pay too much?

Let’s attack Brinson’s observation from a different direction. If, as he suggests, the base fee for active management is closer to what you’d expect to pay for a passive strategy, then perhaps a more useful exercise would be to break down a manager’s performance into its alpha (excess return not related to the market’s movement) and beta (marketrelated return) components to calculate just how much you are really paying for alpha.

Effectively, by disaggregating performance into its alpha and beta components, and assigning a passive fee to the beta component, you could back out the “true” cost (carry) of the alpha component of return from the manager’s active management fee. That was exactly the approach proposed in 2004 by the Hewitt Investment Group (HIG), a British-based consulting group. They termed this concept “alpha carry”. HIG believed the concept of “alpha carry” could be used as a way to assess the relative attractiveness of one investment product against another after the fact (ex-post).

We applied the HIG measure against a representative sample of South African unit trust value managers. In this exercise we’ve assumed that investors could obtain a passive equity (beta) exposure at 10bps. We’ve used the actual fees charged by these unit trusts in our calculation of the alpha carry. Strictly applying the “alpha carry” calculation methodology leads us to conclude that Fund A delivered the most alpha over that period and charged the least for that alpha.

But while the HIG approach to calculating alpha carry may have intuitive appeal, disaggregating alpha and beta strategies may be more complex than anticipated.

For many managers their beta bets (ie, the degree to which the manager exposes the fund to the market’s systematic risk) are also viable strategies for them to earn excess return (alpha) and, as such, that strategy deserves to be rewarded with more than purely passive fees.

The other limitation of the “alpha carry” methodology is that it can only be used on an ex-post basis. As such, it provides little insight into future alpha carry. Knowing that past performance is no guide to future performance we certainly don’t want a framework that merely rewards asset managers for last year’s outperformance – particularly as reversion to the mean in manager performance appears to be more the norm than the exception.

The AVAdd index The real limitation of the HIG methodology is that it fails to recognise that success in long-term investing owes as much to lowering investment risk as it does to absolute outperformance. We believed that if wecould enhance the HIG alpha carry methodology to recognise both the excess return and the resultant change in risk, that this measure would be a better reflection of an investor’s true long-term priorities. Now the formule reads as follows: Value add = Fund performance – Benchmark performance
                                                             Volatility of portfolio/Volatility in benchmark

That means that the value add of an active manager could be higher than another fund manager’s if he:

• Outperformed his benchmark by a higher margin or/and
• Reduced volatility in his portfolio relative to the benchmark with a higher margin.

Applying this new approach to our same value unit trust universe it’s apparent that now Fund G, not Fund A, added more value. By using the AVAdd index it was clear that in this specific instance it was risk reduction, more so than active performance, that dictated the final ranking outcome.

How can we take the debate forward? While our paper may not have been able to identify a single definitive way to assess manager fees, perhaps it has provided a useful basis for getting the discussion going between asset managers and their clients.

Fees matter. And there may well be some justification for believing that, as Brinson suggests, asset management fees as they’re currently structured may well be excessive for the type of returns that you can expect from active managers.

But if you’re jumping to the conclusion that the obvious way to address that issue is to simply resort to performance- based fees, think again. Studies show that the base fees for most performance-based fees don’t nearly approximate passive management fees. As such, at the total expense level, there are serious questions as to whether these types of fees – where you’re theoretically only paying if you outperform – don’t also exceed the cumulative value-add of a given strategy.