Of Course They Are Going To Pick Above Average Managers!!

I had the pleasure of attending the Opal Conference in Newport, RI the last few days. Opal’s “Public Funds Summit East: Navigating the Future” was well attended by public fund trustees, asset consultants and investment management professionals. I will provide a general overview in a later blog post, but I want to dedicate this text to an issue related to investment management fees.

I was particularly disturbed by a comment by an asset consultant when the issue of performance fees was raised. This consultant was troubled by the notion of paying performance fees to managers of any ilk because managers are chosen by his firm who can and will add value, so why pay more for their services? How naive!

Just prior to this panel’s discussion, we were implored by a plan sponsor to seek economies of scale, while also being cognizant of fees (all fees, and not just investment manager fees), as they can be destructive to a plan’s long-term health. I absolutely agree.

Even if a consultant thought that a manager had the above average ability to provide an excess return on a fairly consistent basis, why would they or their clients be willing to pay a manager their full fee without the promise of delivery? As a reminder, the “average” manager will return the performance of the market minus transaction costs and fees.

It is fairly easy to calibrate the performance fee with the asset-based fee based on the expected excess return objective. If the manager achieves the return target, the fees paid should be roughly equivalent, with perhaps the performance fee relationship paying slightly more as compensation for the manager assuming more risk. However, in no case should the performance fee reward a manager to a much greater extent than the asset based fee would have generated.

If the manager truly has the ability to add consistent value, they should be comfortable assuming a performance fee. Importantly, the plan sponsor shouldn’t fear the injection of more risk into the strategy, as the manager is not likely interested in jeopardizing their reputation for a few more basis points. In addition, there are easy ways to track whether this is happening.

Lastly, paying flat asset-based fees in lieu of creating a more incentive based compensation structure is just wrong. Plans should be happy to pay fees based on value-add, but should be infuriated when forced to pay an asset-based fee for the usual less than index return.

KCS has a white paper on this topic that can be accessed on the KCS website. Don’t hesitate to reach out to us if you’d like to discuss this issue in greater detail. Asset consultants are kidding themselves (and their plan sponsor clients) if they think that they will only pick above average managers!

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Asset Consulting Firms and Their Consultants Aren’t Commodities

The environment for asset consulting firms is quite challenging.  Historically, there have been few barriers to entry, and measuring the value-add provided by the asset consulting firm has been difficult to gauge.  As such, hiring decisions have often come down to price, with the low bidder more often than not winning the assignment.  For those firms fortunate to be given an assignment, the life cycle of the relationship is generally fairly long (about 7 years), as it usually takes a departure of the consultant or a major screw up before the relationship is terminated.  This practice has to change.

Given the current state of defined benefit plans in the US and abroad, this is not the time to fiddle while Rome burns. It is imperative that asset consultants be judged for the value that they bring to a relationship, and they should be compensated based on that value-add.  There are many services that consultants provide, but the importance to the success or failure of a plan varies widely.  Establishing the right plan benchmark is critical, and it isn’t the ROA. We believe that it should be the plan’s specific liabilities. The investment structure and asset allocation that flows from a greater knowledge of the liabilities are key decisions that drive most of the plan’s subsequent return. However, it seems to us that most of the time (80/20 rule) is spent on trying to identify value-added managers. Get the wrong asset allocation and the best performing managers in the weakest asset class won’t help you much.

Let’s see if the industry can refocus on the importance of DB plans, so that we can stabilize the retirements for both our private and public workers.  As such, let’s begin to evaluate consulting firms that can improve the funded ratio and funded status, while minimizing contribution costs. These are the important metrics when evaluating a consulting firm and their consultants.  Experience matters in this industry.  We pay great homage to it on the asset management side of the business.  Why isn’t this as critical when evaluating asset consultants?  Remember: asset consultants have a greater impact on your plan than any individual manager does!