Commentary: Performance fees – new hope for active managers?

In 1994, Jeff Bezos founded Amazon.com, which from humble beginnings created the "Amazon effect" that would redefine customer experiences and distribution. Twenty-five years after its creation, Amazon proved it could modernize distribution in any industry with a relentless focus on giving consumers the edge. Amazon changed the rules, and not every retailer was prepared to play the new game.

The same is true in asset management today. Many larger entities are more focused on scaling their operations than innovating to align with their end customers. Well-capitalized, small- to midsize firms appear to have a distinct advantage with more flexible business models, which can give rise to new brands that create modern distribution models with better customer alignment and flexibility.

Just as Amazon's customer-focused tactics changed buyers' expectations, asset managers can rebuild the confidence of asset allocators with better alignment by giving asset owners an asymmetric advantage.

Flexible, risk-based performance fees that mathematically alter the probability of winning can be a new hope for the industry as part of realigning with investors. Fee structures and their related asset classes should reflect the proper market rate for beta and offer fee symmetry relative to the potential for the assets to give investors a statistical advantage. Effectively, asset owners avoid overpaying for below median or slightly above average performance that compounds over the long term.

Japan's ¥159.2 trillion ($1.47 trillion) Government Pension Investment Fund introduced performance-based fees in 2018 to foster "win-win" relationships with its external managers. As the largest pension fund in the world, it opted for the new performance fee structure over low fixed fees, signaling a potential radical shift in solving the alignment problem.

While performance fees were historically common in hedge funds and private equity, they have the potential to become more commonplace for traditional active mandates and serve as a new alignment tool for large and small asset allocators. As a result, base fees would be lowered to align with the cost of beta and paired with a performance fee that is paid when managers deliver alpha, including clawback provisions.

According to a July 22 Pensions & Investments story, the first official results recently released by the Tokyo-based giant suggested "many (managers) aren't feeling like winners," and why would they?

Inconsistent performance in active management and volatility in the short term can be challenging, but fixed fees during these periods act as a tax on net of fee performance if there is underperformance. That, along with a lack of fee flexibility, has contributed to many of the failures we see in the active management industry today. Innovative performance fee structures are new tools that have the potential to lower fees for investors. This is underscored when considering the probability and persistence of favorable outcomes typically associated with active manager selection.

Last year, it was noted in the P&I story that GPIF experienced a 40% plunge in fee payouts as a result of its new performance fee structure. The decline in fees appears to be representative of a sample of active manager performance across a distribution of performance occurrences resulting in a scenario where only 10% of active managers receive the max fee cap; 50% of managers are receiving a low, passive-like fee; and 40% of managers are somewhere in between.

Larger firms certainly have the size and scale to compete at any price on any one investment mandate. However, we believe larger firms with significant assets under management may struggle with converting to a more flexible revenue model across their business that aligns fees with the true value of active management. Here are five reasons why:

1. Cannibalization of revenue. Larger firms risk cannibalizing legacy products by adopting performance fees across an expansive product array embedded with a fixed-fee footprint in the marketplace. Smaller firms can expand new products or convert low-revenue base products more easily, with less cannibalization risk and conflicts of interest on a smaller scale.
2. Culture and politics. Firms must fully commit to a performance fee model or even a hybrid model to be successful. True alignment is part of a larger firm philosophy emphasizing performance fee and pricing flexibility with investors. Long-term employees and portfolio managers who have standing compensation models aligned with asset gathering will scrutinize performance pricing. As reported in the P&I article, "the absence of Boston-based money management giant Wellington Management Co. from GPIF's latest list of foreign equity managers — for the first time in five years — is a case of a manager walking away from the new system." Small- to midsize firms can embrace a more entrepreneurial culture and move innovation forward.
3. Variable fee dynamic. Smaller firms can more readily adapt less complex business models to prepare for more variability in revenue and profitability. Smaller boutique firms with outsized alpha can better exploit their skill to grow assets and avoid the erosion of AUM without compromising profitability over the long term.
4. Portfolio manager compensation model. Portfolio managers who are equity owners in smaller, midsize boutique firms may be more open to compensation structures heavily weighted to performance objectives vs. product-based revenue compensation.
5. Fund conversions. Small- to midsize firms may have strategies with successful, established track records and low levels of AUM. This allows for more flexibility to convert to a performance fee structure without compromising large sums of revenue or potentially triggering most favored nation clauses, which would in turn ensure institutional investors pay the lowest investment advisory fees money managers offered for similar accounts.

A renaissance in the active management industry will need to be focused on increased flexibility and better alignment with the end investor. Asset allocators and consultants need to educate themselves on the mathematical benefits and trade-offs vs. fixed fees using simple break-even and probability analysis. Ultimately, we believe risked-based performance fees present a real opportunity to improve alignment with asset owners and have a positive impact on institutional investors.

Phil DeSantis is senior vice president and head of product management at Dallas-based Westwood Holdings Group. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.