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Money Management

Shakeup due in equity manager fee structure

Douglas Eu believes it’s hard on managers to switch to a performance-fee model.

Expectations of lower investment returns, and the resulting lower profit margins for money managers has some industry observers saying it's time for active equity managers to radically change their fee structure.

"This beautiful bull market we've had so long, you'd think fees don't matter," said Steve Voss, senior partner, Aon Hewitt Investment Consulting, Chicago. "But with increasing transparency and the fact that the bull market will end, I think it's reasonable to see 5% to 6% (annual) equity returns in the future and 1% to 3% for fixed income. That will have a greater impact on lowering fees and changing structures."

Added Christian Edelmann, partner and global head, corporate and institutional banking and wealth and asset management, at management consultant Oliver Wyman, London: "There's a lot of experimenting, but not a lot of change on the asset management level. It's mostly still negotiation, with asset owners using existing structures."

The impact on margin, said Mr. Edelmann, is evidenced in a March 16 report he co-authored with others at Oliver Wyman and New York-based Morgan Stanley (MS). The report shows margins among money management firms have started to decline and will continue.

From 2011 to 2016, the report said, managers' cumulative assets under ​ management grew an annualized 6% while revenue grew an annualized 4%. In 2017, AUM rose 13% and revenue increased 9% — a 4-percentage-point spread compared to the 2-percentage point spread in the previous years. Also, the report said, annualized overall costs were 3% from 2011 to 2016, but 8% in 2017. Margins — the difference between revenue and cost — were an annualized 1.5 percentage points from 2011 to 2016 but only 1 percentage point in 2017.

And by 2020, the report continues, AUM is expected to rise a cumulative 10% while fee pressures and a continued move by investors to passive investment will lower revenues by 13%.

"Lower market returns combined with fee pressure will force the industry to evolve its stubborn cost structure," the report concluded.

Cutting costs

Managers have responded to the decline in margins by cutting their own costs, particularly on the operational or back-office side, with explorations of the use of blockchain, artificial intelligence and machine learning to create economies of scale.

So why not undertake a similar review of how fees could be restructured to remain competitive while also maintaining, or even improving, margins? The inertia among most managers is the result of a long-running bull equity market that has provided sustained asset growth, said sources, but that won't last forever.

"Those that already have scale have been sitting in beta that's been about 15%," said Douglas Eu, Los Angeles-based CEO-U.S. of Allianz Global Investors. "That's just because the market gave those returns. If beta doesn't hold up, how will the business sustain that business model?"

And it's not just managers' inertia. Divyesh Hindocha, London-based senior investment consultant at Mercer LLC, said most asset owners "are comfortable with the current bargain — high fees and taking the alpha. That will continue for a long time."

Additionally, Andrew McCollum, managing director, investment management, at Greenwich Associates LLC, Stamford, Conn., said fears of change among fiduciaries and manager issues like the internal complexity of making such a structural change, along with the lack of innovation in fee structures in general, makes such change difficult.

The changes managers have done have been incremental, said Mr. McCollum. For example, using fulcrum fees — variable fees used in retail mutual funds — and applying them to institutional portfolios, as Fidelity International has done with 10 equity strategies, or instituting fees based exclusively on beating a benchmark, as is now being offered by Allianz Global Investors with three institutional products.

Mr. McCollum said alternatives firms have been offering performance-only fee structures, "but now you see traditional asset managers and big multiasset-class firms beginning to do this. And that's new."

The Fidelity International fee model launched March 1. In its October 2017 announcement, Fidelity said the 10 funds would carry a management charge that was 10 basis points lower than their previous prices and then would increase or decrease the fees by 20 basis points on a three-year rolling basis based on whether the funds performed above or below their benchmarks. Meanwhile, AGI introduced three actively managed institutional products with all fees based purely on performance above benchmarks, with no accompanying flat management fees: its Best Styles factor-based portfolios and advanced fixed-income strategy, which each have a 20% performance fee for any alpha, and a structured alpha strategy with a 30% performance fee above the benchmark.

Efforts to reach officials at Fidelity International were unsuccessful.

Performance-only fees

AGI's Mr. Eu said making the change to a performance-only model, even for just a few strategies, is a major move for any money manager. "If you're a traditional asset management firm with a certain type of assets in an asset class, it's hard to change, period," Mr. Eu said. "That's in every industry. Larger players have a hard time changing themselves because they have a lot invested in the status quo. I hear people mumbling about it, but that's not the same as offering it. I'd say not every asset management firm can move there. … You're using pricing as a disrupter in the industry." AGI managed $598 billion in worldwide assets, including $421.5 billion in institutional assets, as of Dec. 31.

However, Oliver Wyman's Mr. Edelmann doesn't view either the AGI or Fidelity change as a paradigm shift, instead seeing them more as minor changes to an established fee model. "Change hasn't really arrived at any of the dominant players," he said.

There has been one idea that would radically change the traditional fee structure, suggested by Mercer's Mr. Hindocha in a report that was released in October. In it, Mercer proposed making money managers pay asset owners to manage their assets, and then take back a prearranged performance fee for any alpha the portfolios gain. Mr. Hindocha said in an interview that he wanted to "resurrect the idea of active management" but that simply reducing fees would encourage a "race to the bottom."

"What we really need to do is start with active management from a completely different perspective," said Mr. Hindocha. "That led to, let's just turn it completely on its head."

Mr. Hindocha said the proposed active management model would work alongside the established fee model, not replace it. Managers would pay asset owners a fixed annual fee to manage their money, plus an agreed upon market return to keep market risk with the asset owner. The manager then retains all of the returns over a specified benchmark.

"In effect this results in guaranteed active management," said the Mercer paper.

Mr. Hindocha said he's had a number of conversations with money managers, with differing reactions, although he's also unsure that "everybody understands what's being suggested. A lot of reaction still seems to be that this is about fees — I'm saying it isn't: It's fundamentally about finding a mechanism to resurrect active management, but with a new bargain."

Full impact hasn't hit yet

At Parametric Portfolio Associates LLC, Seattle, Brian Langstraat, CEO of the $240 billion money manager, said he doesn't think margin issues have hit the industry just yet.

"We've made no changes (in fee structure) at Parametric," Mr. Langstraat said. "I don't know that margin compression has really hit the industry yet, largely because even though asset flows have been negative and costs have gone up, the bull market of the last decade has had the accretive revenue experience, and most managers have been able to maintain margin," he added.

"I think (managers are) rightfully worried about that because growth has come from market appreciation as opposed to organic growth. I think you may see a lot more innovation move out of the laboratory into the real world when we have a period of negative market returns or flat market returns for a while, and management teams don't see margins maintain or even grow as a result of market action," Mr. Langstraat said.