Split of alpha, beta shifting more risk back to money managers
By Thao Hua | November 26, 2012
Institutional investors are increasingly separating beta and alpha in their fee structures to shift more of the investment risk back to their money managers.
The reasons: difficult market conditions producing a buyer's market and advances in technology that allow for a more precise determination of return sources. The evolution of systematic approaches such as smart beta strategies also added pressure on active managers.
For example, Towers Watson & Co. is working with pension funds across the globe to change fee structures so clients retain a fairer proportion of the alpha. In some cases, more than 100% of the alpha generated goes to the manager over time, sources said.
“We still believe the best active managers can add a lot of value,” said Craig Baker, global head of research at Towers Watson in Reigate, England. “But in many cases, even the good active managers are unattractive because fee structures are designed such that the vast majority of the value they add is kept by the investment manager rather than the asset owners, who are taking the risk.”
Among those institutional investors strengthening the beta-alpha separation component in fee structures are the $6.5 billion Wyoming Retirement System, Cheyenne; the 3.7 trillion Norwegian kroner ($653 billion) Government Pension Fund Global, Oslo; and the $83 billion State of Wisconsin Investment Board, Madison.
“We want to really make (fee structures) fairer, with interests more aligned,” said John Johnson, chief investment officer at the Wyoming fund. The pension fund is overhauling the fee structure across its entire $3.5 billion long-only equities portfolio, paying active managers a base fee similar to passive management in addition to a performance fee, but with a slight twist.
“Performance is recalculated on a monthly basis, using actual dollars earned in excess returns, and accrued in a performance-fee bank,” Mr. Johnson said. For example, if the manager made $10 one month and lost $10 the next month, that manager hasn't earned any performance fees.
“The other key is that we pay half of the performance fees on an annual basis, with a one-year hold-back” provision, he added.
New fee structure
Norway's GPFG, the world's largest sovereign wealth fund, launched a new fee structure two years ago, and negotiations with external managers - which are all equity firms - were completed at the end of 2011.
“What sparked the need for the new fee structure was a change in strategy with regard to external managers, from having broad mandates to more specialist strategies” with country mandates in emerging markets and small-cap country mandates in developed markets, said Erik Hilde, global head of external strategies at Norges Bank Investment Management. NBIM manages the global fund, which allocates about 7% of total equity assets to outside active managers.
Investment management costs for the average pension fund have generally declined since the 2008-2009 financial crisis, mainly because of lower performance-related fees, Towers Watson's Mr. Baker said.
Furthermore, a lower-return world has helped tip the balance of power between money managers and clients, leaving more investors better positioned to scrutinize fee structures, sources said.
“We cannot tell in the long term whether (advances) in fee structures will shift back” to the pre-crisis environment, said Ludovic Phalippou, lecturer in finance at Oxford University's Said Business School, Oxford, England, who has extensively researched embedded costs in private equity fee structures. “The real test is perhaps another bull market, and whether we will again see the wrong incentives” for managers within fee structures, said Mr. Phalippou.
Total investment costs average between 80 and 100 basis points, nearly all of which is equally split between manager and transaction fees, Towers Watson estimates. “One way of cutting costs is to reduce turnover to keep the brokerage cost down,” Mr. Baker said. “The other obvious avenue is to keep asset management fees down.”
For example, by changing the period over which performance fees are calculated to a longer time horizon, investors might save a considerable amount in fees. “That's without changing the headline fee; that's just changing the way the calculations are done,” Mr. Baker said.
Investors believe performance fees align interest because they're only paying out high fees if and when managers produce good performance, Mr. Baker said. In reality, however, “most are designed in such a way that benefit managers more because when a manager does well, they're paid a performance fee. But when they do poorly, they don't take off an underperformance fee.”
At NBIM, fees are calculated monthly but paid out annually and include hurdles and high-water marks. In the initial years, only a percentage of the fees are paid, subject to cap and clawback provisions. However, after a certain number of years, the payout rate is increased up to 100% annually, but still subject to a cap.
Fee calculations at NBIM are based on value created in U.S. dollars and not by percentage of outperformance in order “to fund additional assets without being hampered by past performance,” Mr. Hilde said. So far, the new fee structure has helped “to lower the (fund's) cost for those managers that have not generated excess return over time,” he added.
“For those managers that have created excess return or value for us, it hasn't really lowered the cost, but aligned the interests of the manager with our interests as a client,” he said.
David Villa, CIO at the State of Wisconsin Investment Board, Madison, has a different view on how to implement beta-alpha fee structures within the investment process.
“We don't think of fees as something you spend a lot of time negotiating. The way we think about fees is more of a screening paradigm,” Mr. Villa said.
4 building blocks
The framework for assessing managers is applicable to any active strategies based on four building blocks of investment returns: the cash rate; the market beta; the hidden beta or non-traditional market beta and the alpha component. Fund executives first isolate those managers with investment returns that are dominated by alpha, and then determine how fees are charged in relation to the return stream, said Dominic Garcia, Wisconsin's senior funds-of-funds alpha manager.
“What we've found is that those managers that pass the (fee structure) screening were typically also managers that meet most if not all of our core beliefs” in terms of what we look for in a manager, Mr. Garcia said. The fee screening became “an augmented measure to help us confirm our views of managers.”
At the Wyoming Retirement System, pension fund officials are considering expanding the beta-alpha fee structure to credit and fixed income. In addition, plans to apply the same concept to hedge fund fees are also likely. Wyoming has a target allocation of 10% for credit hedge fund strategies within its $1.6 billion credit portfolio and a separate 10% allocation to long/short equities within the equity strategy.
“What we're working on next is how to strip out the pure alpha from the effects of beta” and leverage, Mr. Johnson said. “The difficulty is coming to terms with managers about what is alpha and what is beta. ... Most managers' perceived alpha is really beta.”
Fee structures within alternatives can be even more unbalanced in favor of managers, but overpaying for beta is a broad concern affecting all asset classes, sources said. Some hedge funds are considerably cheaper than some long-only strategies. “They may not look at it in terms of headline fees, but they are when you calculate what proportion of the alpha that's being produced that is being paid away in fees,” Mr. Baker said.
“There's a lot (about fees) that investors haven't thought about; that's why they're overpaying for asset management services,” Mr. Baker said.
This article originally appeared in the November 26, 2012 print issue as, "Split of alpha, beta shifting more risk back to managers".