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.