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August 22, 2005 01:00 AM

Pros and cons with traditional strategies

Cecily O'Connor
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    Money managers say the use of performance fees in more traditional mandates is growing, but not at a strong pace.

    More than 60% of investment managers and 30% of plan sponsors used performance fee structures for at least some of their traditional investment mandates in 2004, according to a survey of 166 investors and 134 managers by consultant Callan Associates Inc., San Francisco. That is up from 37% of managers and 12% of plan sponsors in 2000. The study did not break out traditional strategies and alternatives.

    Christopher Pope, State Street Global Advisors' senior principal and director of institutional sales, client service and consultant relations, wrote in an e-mail: ``The trend toward performance fees is definitely here in a significant way.''

    But the trend is not without a downside: ``Clients have to be aware that a manager can earn a substantial fee if they perform modestly above expectations,'' he said.

    Jeffrey States, chief investment officer of the $4.8 billion Sacramento County (Calif.) Employees Retirement System, said: ``A performance fee - and my board has gotten more comfortable with it - makes you feel like you aligned your interests a little bit better'' with the manager.

    Mr. States said his board has stepped up its use of performance fees during the past two years in most new contracts. During that time, Mr. States said, Sacramento County had about six new or renegotiated contracts calling for performance fees in the system's equity mandates, including international equity and large-cap value. The fee structure isn't much different from what's used in alternatives, he said. ``In almost any contractual relationship, we'll consider whether (performance fees) are appropriate or not.''

    While the Callan data show a steady increase in performance-fee use, the more traditional equity managers interviewed for this story said investors are not wild about the practice.

    Franklin Templeton Institutional, a subsidiary of Franklin Resources, Inc., San Mateo, Calif., has two of several hundred clients that use a performance-based fee structure in their domestic all-cap equity and U.S. equity mandates, said Reed Hutchens, director of U.S. institutional sales and client service.

    Clients might ask, ``Are you willing to do a performance fee?'' he said. ``Sure, we're willing. But when things are said and done, it usually goes back to the standard fee schedule.''

    Richard Pzena, chief investment officer of Pzena Invesment Management LLC, New York, with $10.7 billion in assets under management, said the firm offers performance fees in all of its equity strategies, but ``very few'' clients go that route.

    Clients ``think if the performance is good, it's cheaper for them to have a fixed fee,'' he said.

    Jennie Paterson, global sales and marketing director at AXA Rosenberg Group LLC, Orinda, Calif., said the firm has seen a ``slight increase'' in the use of performance fees by clients investing in U.S. small-cap and midcap equity strategies.

    At the same time, some consultants argue that regardless of a shift to performance fees, the industry has a built-in incentive structure.

    Simply put: ``You keep performing to expectations, you get paid,'' said Michael Beasley, co-founder of Strategic Investment Solutions, a consulting firm in San Francisco.

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