CHAMPAIGN, Ill. - The State Universities Retirement System of Illinois, using performance-based fees, paid some managers almost double their standard fees in the last year, while one manager received nothing.
But it takes more than overcoming a performance hurdle return to stay in the good graces of the $7.5 billion pension fund.
One manager outperformed its benchmark, yet still was terminated.
Overall, the system outperformed its policy benchmark by 40 basis points and exceeded the Trust Universe Comparison Service public fund index peer group. Officials of the system are reluctant to attribute the performance to the fee structure, although they acknowledge the structure has sharpened the focus of money managers on the system's objectives.
They don't consider performance fees incentive fees.
"I don't know that they (money managers) work for us any harder or for another fund any less," said John R. Krimmel, associate investment officer.
"It aligns the interests of the managers with the system. If the manager does well, they earn a performance-based fee.
"Performance-based fees ensure we are paying a reasonable amount. Each schedule has a maximum."
Kenneth E. Codlin, chief investment officer, noted, "Performance-based fees provide a clear understanding of our objective. When you tie the payment of compensation to a performance benchmark, it makes the standard very clear.
"It assures good communication of our benchmark."
Four of the system's five active domestic equity managers were on performance-based fees.
Equity manager fees detailed
Of them, the only one that earned performance fees and was retained was Smith Barney Capital Management, New York.
Smith Barney was projected in the system's budget to receive $381,508 for the fiscal year ending June 30, 1997, consisting of $195,603 in a base fee and $185,905 in a performance fee. It manages $120.6 million in a portfolio benchmarked 60% to the Wilshire 5000 index and 40% to the Wilshire large value index.
The system didn't have available a breakdown of the amounts paid to the managers for the most recent period, only the projected amounts, and amounts paid in the fiscal year ended June 30, 1996.
Three equity managers were terminated in September:
Rosenberg Institutional Equity Management, Orinda, Calif., outperformed its Wilshire 5000 benchmark and earned a performance fee. But Mr. Krimmel said Rosenberg's performance "was not at a level to warrant retaining." It managed $120 million for the system.
Holland Capital Management, Chicago, earned its base fee but no performance fee. Holland, which Mr. Krimmel described as a growth at a reasonable price manager, managed $33.5 million for the system.
Fisher Investments Inc., Woodside, Calif., was projected to receive nothing for the latest performance period, between June and September 1996, because it underperformed its benchmark. For the year ended June 30, it was paid $104,608, including an $84,000 performance fee. It managed $47 million for the system, benchmarked to a Valueline index.
Fisher, a small-capitalization value manager, was the only one of the system's managers to agree to performance-based fees only, with no base fee.
Fayez Sarofim & Co., which manages $410 million, is the only domestic active equity manager not on a performance fee.
Brinson Partners Inc., Chicago, is the only one of the system's three international equity managers on a performance fee. It was projected to receive $506,205, including a $212,753 performance fee. Brinson's fee for the fiscal year ended June 30, 1996, wasn't available.
Brinson manages $147 million, benchmarked to the Morgan Stanley Capital International Europe Australasia Far East Index.
IDS International Inc., Minneapolis, and Martin Currie Inc., Edinburgh, Scotland - the system's other international managers - haven't come to terms with the system on performance fees. They receive traditional asset-based fees. Mr. Krimmel said the system would like all of its active managers on such fees.
Bond firms on performance fees
The system's five fixed-income managers are all on performance fees.
BlackRock Financial Management, New York, was projected to receive $412,062, including a $264,897 performance fee. For the year, it received $268,457, including a $160,475 performance fee. It manages $147 million for the system.
Chicago Trust Co., Chicago, was projected to earn a $33,617 base fee and no performance fee. It manages $28 million for the system. The fee it was paid in the previous fiscal year wasn't available.
Pacific Investment Management Co., Newport Beach, Calif., was projected to receive almost $2.4 million, including a $1 million performance fee. For the previous year, it received $1.3 million, including a $651,000 performance fee. It manages almost $1 billion for the system.
Standish Ayer & Wood Inc., Boston, was projected to receive a $140,000 base fee and no performance fee. Its fee for the year was unavailable. It manages $56 million for the system.
Zurich Investment Management, Chicago, was projected to receive a $65,752 base fee and no performance fee. It received a $32,291 base fee for the year. It manages $56 million for the fund.
On Rosenberg, Mr. Krimmel said, "We had expected them to do better than they did. Even though they beat the benchmark, they didn't meet the objectives the board was hoping they would meet."
Stephen Dean, portfolio engineer at Rosenberg, confirmed the reason for the termination.
"We did beat the benchmark but not by what they were expecting," he said.
"It is interesting they didn't set it higher," he added, referring to the hurdle for receiving performance fees.
About half of Rosenberg's clients place it on performance fees.
"We're indifferent to it," he said. "It's hard to set the terms."
Gary Brinson, president of Brinson Partners, said, "In almost all cases we'd be willing to construct a performance-based fee schedule" for clients. "We're indifferent to performance fees, as long as it's appropriately structured.
"Our assumption is we'd earn the normal fee over time with some variability," he noted.
"A performance fee is more about a synchronization of what we're paid and how the portfolio is performing.
"Incorrectly, people use the term incentive fees," Mr. Brinson said. "I take exception to that use. It has no incentive affect."
"Over time there is no advantage or disadvantage to us or the client of performance fee or a normal fee schedule," he added.
Performance fees "have no impact whatsoever in managing a portfolio," he said, saying Brinson Partners doesn't work any harder for performance-fee clients than asset-fee clients.
"The investment people don't even know which portfolios are on performance fees."
Mr. Brinson said less than 10% of Brinson Partners' clients put it on performance fees. In fact, "in the last couple of years, there may have been a diminishment."
James Dawnay, director at Martin Currie, said, "We aren't advocates of performance fees."
"The implication is a performance fee will make a fund perform better. That would mean taking more risk" than the policy objective.
Such fees also suggest that a firm might be making different decisions on behalf of different clients, depending on the fee arrangement, he added.
He said only a few clients pay performance fees.
Charles F. Henderson, chief investment officer, Chicago Trust, said, "We welcome the opportunity to have performance fees, but with one caveat: that the base fee is reasonable and the bogey is reasonable."
"Clients have to be sophisticated investors to construct a fair performance-based fee schedule," he added.
"The bogey really becomes a function of the current investment climate and what the financial markets are doing. A 25-basis-point outperformance when the benchmark return is 10% is not that big of a deal. But when the benchmark return is 4%, it's a challenge. That's a component that maybe ought to become a variable."
Like other managers, he said Chicago Trust doesn't work harder for clients on performance fees compared with those on asset-based fees.
Less than 10% of its clients are on performance fees. "I don't see any great groundswell of support for performance-based fees," he added.
Consultant supports the move
James Knupp, principal, Ennis Knupp & Associates, Chicago, the system's consultant, said: "We supported" the move to performance fees. "This is a controversial area."
"We don't ever envision this as an incentive" for the manager to work harder, he said.
"For SURS, it's a notion of equity" or fairness, he said. "They aren't paying (normal) fees if they aren't getting performance. . .
"Performance fees make very explicit what's expected of the manager, not just, say, beating the S&P 500, but surpassing it by a specific expectation. It clarifies what the expectations are."
Also, Mr. Knupp said, performance fees "are a way to reduce or lower manager fees."
Ennis Knupp has "not been a major advocate of performance fees. Unless it's a large client with a staff, it's time-consuming to administer, negotiate and calculate. We've not against performance fees either."
For SURS, performance fees helped emphasize that the focus of active management is value added, he said. "It has tried to align expectations with manager compensation. It has had the effect in a minor way of controlling costs."