At a recent Opal Public Funds conference in Newport, RI, the conversation turned to fees, and specifically to performance fees for long-only mandates. As usual, there seemed to be less acceptance of these fee structures for long-only products than there is for “alternative” product. I don’t get it! What’s the difference?
Why would any plan sponsor or consultant be willing to pay a long-only manager their full fee with absolutely no promise of delivering an excess return? One of the arguments raised was the “likelihood” that a manager would try to juice returns. I don’t know about that argument. Why would any asset management firm jeopardize their entire franchise to try to earn a few extra shillings? It doesn’t make sense! Furthermore, why are you hiring that manager in the first place if you don’t trust them to be good shepherds of your money?
Years ago, when I was involved in the Invesco quant area, we had roughly 10% of our client mandates on some type of a performance fee schedule, and these weren’t just market-neutral, 130/30 or portable alpha clients. We actually encouraged our clients to use performance fees for long-on mandates, and not because we thought we might earn more in fees, as we calibrated the performance fee and asset-based fee at the targeted excess return. Our rationale was that it was better for the client, and thus, better for us in the long-term.
If a plan sponsor or consultant is leery of excess risk being injected into a product using a performance fee, just ask to see a list of all the returns and tracking errors for the clients in that particular product. You don’t need to see the name of the client, but it will be pretty obvious if they are running your mandate more aggressively than they are the others.
One of the contributing factors in the movement to passive investing from active management has been the lack of “reward” for the fees paid. Using a performance fee schedule, and we’d recommend a high watermark methodology as opposed to a moving average arrangement, is one way to ensure that you won’t be paying more than index fees for sub par active performance.
Don’t hesitate to reach out to us if you’d like to discuss this subject in greater detail.