Asset owners are putting increasing pressure on investment management fees, shifting asset allocations more toward lower-fee factor-based strategies, index funds and newer strategies, as well as negotiating tougher contract terms and even resorting to lawsuits.
Will such pressure undermine the quality of portfolio management, ultimately weakening the investment process' ability to add value and harming outcomes for asset owners?
Charles D. Ellis, founder of Greenwich Associates, a financial industry research and consulting firm, has an answer. Writing in 2012 in the Financial Analysts Journal, he believes it is a “delusion” to view investment management fees as low.
Do managers in turn ask if their high fees undermine investment objectives of their fiduciary clients? Many, probably most of them, haven't done so. They should, because they have a fiduciary obligation to act in the best interests of their fiduciary clients, and risk losing those clients under the increasing focus on fees. Taking such action would help shed needed light on their shortcomings and ideas for addressing them.
Asset owners have a fiduciary duty to seek the best contract terms and pay no more than fair market value, and better align their interests with those of investment managers.
In a low-interest-rate environment, with weak market returns making it difficult to gain the asset growth needed to meet obligations, fees become magnified compared to returns.
But the fiduciary duty applies regardless of the market environment. Asset owners must keep pressure on managers, challenging fees and investment processes that fail to add value.
Some clients have been focusing on the challenge of getting higher returns by embracing newer strategies to improve outcomes and reduce fees.
In fixed income, for example, asset owners recently have embraced buy-and-maintain credit strategies. Such an approach straddles flaws in passive management, such as forced selling, which raises trading costs, and in active management, which has higher fees and return volatility.
In foreign exchange trading, pension funds have been negotiating better terms with custodians or even bypassing them entirely to achieve lower costs and best execution.
A driver of the increased focus has been lawsuits filed since the financial market crisis by pension funds against custodial banks accusing them of charging excessive fees on foreign exchange trades. Last December, the $18.3 billion Teamsters Central States, Southeast & Southwest Areas Pension Fund, the $2.7 billion Verizon Savings and Security Plan for Mid-Atlantic Associates, and the $931 million Owens Corning Merged Retirement plan filed a lawsuit against Bank of New York Mellon Corp. claiming it overcharged on foreign exchange transactions. BNY Mellon at the time said the suit is without merit.
In a separate matter, the Chicago Public School Teachers' Pension & Retirement Fund, also in December, sued 34 investment banks or their units, accusing them of “conspiring to engineer and maintain a collusive and anti-competitive stranglehold over the market for interest-rate swaps in violation of federal antitrust laws,” as well as excessive clearing fees on trades.
Participants have sued corporate defined contribution sponsors over excessive fees in their investment funds and won settlements. The suits challenge the notion that higher fees produce better outcomes for participants.
To their credit, pension funds are tackling the issue. But some have fallen short of their fiduciary duty by not always seeking a detailed accounting of fees and trading execution, leading to underperforming outcomes.
Some asset owners are embracing better transparency on fees to shed light on their impact on investment returns and to put more pressure on managers for their reduction.
The New York City Retirement System last November released its most detailed look at fees, showing $708.9 million paid in the year ended last June 30.
“Bringing these costs out of the shadows is another important step in delivering greater value” for the city's five pension funds, said Scott Stringer, New York City comptroller who oversees their assets.
At the Council of Institutional Investors conference in March, Ash Williams, executive director and chief investment officer, Florida State Board of Administration, in a panel discussion on private equity, recognized the need for more attention. “One can fairly say that more light should be shed in the areas of fees and revenues,” he said.
The Institutional Limited Partners Association has been working with asset owners to develop a standardized template for reporting fees and expenses to provide greater detail and comparability, to better align interests. Some 23 asset owners and 25 private equity managers have endorsed the template as of Jan. 27.
Managers compete not only with their peers but also with asset owners. Some asset owners, like the State of Wisconsin Investment Board and the Florida board increasingly have embraced internal management to reduce fees without sacrificing expected return and risk objectives.
Managers that want to build their assets under management must develop more creative approaches, even in existing strategies, to add value while reducing fees that misalign interests. Some managers, for instance, are looking at ESG analysis as a way to add value and at least maintain fees for active management, to overcome the pressure from lower-fee strategies such as index funds and factor-based investing. Managers that adopt new approaches must show they play out in outperformance to justify fees.
As Mr. Ellis pointed out in the FAJ, fees as a percent of assets under management appear relatively low. But as Mr. Ellis advises, asset owners should consider fees measured as percentage against the risk-adjusted return of those assets. Fees then are “remarkably high,” he notes, pointing out a majority of active managers fall short of their benchmarks.
Managers would do better to take the allocation trends, underperformance and lawsuits into account, and put a greater focus on their investment processes and fees to align them in the interests of their clients. n