A now-famous paper published late last year found that the most prevalent fee structure used by fund managers in the UK market – a fixed fee as a proportion of assets under management (AUM) – is generally “the best structure for the manager and the worst for the investor”.
The four authors of
Heads We Win, Tails You Lose, Andrew Clare, Nick Motson, Richard Payne and Steve Thomas – all academics at the Centre for Asset Management Research at Cass Business School – reached this conclusion after creating a series of models “to gauge the impact of three mutual fund fee structures on the utility of investors and fund managers”. These were: the fixed fee, an asymmetric performance-based fee and a symmetric performance-based fee.
The fact that the fixed-fee arrangement is the most prevalent in the UK market means that fund management companies tend not to go bust because the charging structure they use helps to cushion the negative impact of poor performance and ultimately keeps the wolf of bankruptcy from the door.
This proposition is reinforced by the paper’s finding that the most advantageous charging structure from the customer’s point of view is a symmetric performance-based fee, under which the manager wins when the client wins and loses when they lose. Clearly, symmetric performance fees would leave the fund manager at risk of losing money periodically, and so it’s hardly surprising that they are not queuing up to introduce them.
"The lack of real competition between fund managers is a serious structural weakness of this industry"
The problem, however, is that with the risk of going bust largely removed, the possibility of genuine competition – a Darwinian survival of the fittest – is also greatly reduced. The lack of real competition between fund managers is a serious structural weakness of this industry: it should be entirely possible for poorly performing fund management companies to go bust with no direct harm to the interests of their clients, but this does not happen. The way that fund management services are charged for helps to explain why this is the case.
If one follows the logic of
Heads We Win, Tails You Lose, the conclusion would be that any manager that charges a fixed fee of AUM is implicitly telling the world that they know they are not very good, because in order to do business, they require a fee structure that is the least beneficial for the client under almost all circumstances.
So when do the clients win under the fixed-fee structure? The paper finds this happens only when the managers are extremely skilful and are permitted a big tracking error against their benchmark index (otherwise known as a high active share). Customers do best when these managers perform well by paying them a fixed fee, rather than one linked to performance.
The mystery, therefore, is why managers who can demonstrate high skill and high tracking error do not routinely charge performance-based fees. Either they don’t know how to maximise their own profits, or they lack confidence in their ability to sustain their performance.
What does this all boil down to? In a world where investors can track an index, there is no question of outperformance, so performance fees for these products are irrelevant and a (low) fixed fee on AUM might be a sensible way to charge. But for active management? I don’t think so.
The original version of this article was published in the March 2015 print edition of the Review.