Managers have been incentivised to raise assets, not to perform, and because of this, trust has eroded as clients have grown weary of paying for over-diversified portfolios that simply do not deliver. So how does an industry steeped in legacy and tradition course-correct before it is too late? By implementing innovative new strategies that realign manager and client incentives.
The question of fees and portfolio manager compensation
The first major issue in active management is fees. Not the level of fees, on which most industry discussions have recently focused, but rather the structure of fees. Most firms charge fixed fees as a percent of assets, meaning that managers receive the same fee whether or not they beat their benchmarks. This is true even in firms with performance fees – traditionally many hedge funds have charged “performance” fees on any returns above zero, effectively charging clients for exposure to beta.
This is great for asset managers, but not for clients. And I believe it has a perverse effect on managers by encouraging them to grow assets rather than to control capacity, which in turn makes it more difficult for them to perform. It should be no surprise that investors are tired of paying fees regardless of whether or not their active managers beat their benchmarks.
Active strategies should charge base fees competitive with those of comparable passive ETFs, and as performance is generated in excess of benchmarks, only then should performance fees be levied.
The second major issue is an extension of the first – portfolio manager compensation. Fixed fees create relatively stable revenue streams, which in turn have created relatively stable compensation for managers. But active managers should be compensated based on the results they produce – not the assets they manage.
Taken together, these issues illuminate a clear path forward. Active strategies should charge base fees competitive with those of comparable passive ETFs, and as performance is generated in excess of benchmarks, only then should performance fees be levied. Clients shouldn’t have to pay more than the price of passive unless they actually get more, and this type of structure will help asset management firms find and retain portfolio managers who can create – and are rewarded for – outperformance.
Even in the institutional space where face-to-face meetings with portfolio managers will always be a necessity, there are incredible efficiencies to be had by modernising our sales and diligence processes.
Next, we must change the way clients interact with portfolio managers. Traditionally, retail investors have had almost zero exposure to portfolio managers, and funds have been sold by salespeople through intermediaries. And in the institutional space, investors battle for portfolio managers’ time when what they’re actually paying for is returns.
A revolution in fund marketing and sales is needed. New digital and social strategies can expose managers directly – and personally – to thousands of existing and potential investors without them ever having to leave the office. Managers engage in analysis, education and risk management with their teams every day – we simply need to offer clients a better window into that world.
Even in the institutional space where face-to-face meetings with portfolio managers will always be a necessity, there are incredible efficiencies to be had by modernising our sales and diligence processes. Technology can enable clients to better understand their managers, while simultaneously giving managers back valuable time and resources they can spend investing. It’s a win-win.
Change is not easy, and it will take time. But it is necessary if we are to survive the changes that are already upon us.
More news on the fund industry in Paperjam’s Alfi supplement.