European fixed-income investors demanding fee cuts

European fixed-income investors are pushing for fee cuts from active managers whose performance is suffering.

For this state of affairs, money managers can thank central banks that constructed the persistent low-interest-rate environment as they are finding outperformance is nearly impossible to show when €5.3 trillion ($5.86 trillion), or 50.7%, of European government bonds and 28.3% of euro-denominated investment-grade corporate bonds have negative yields. This heightened focus on fees due to declining yields has been boosted by European and regulators' and investors' "obsession" with costs as well as competition from passive managers, which has become more pronounced in fixed income over the last years, sources said.

"Because of quantitative easing, the liquidity in the corporate bonds market is patchier," said London-based Kate Hollis, director, manager research at Willis Towers Watson PLC, in a telephone interview, adding that the hurdle to make a profitable trade is higher and that gap to find alpha is smaller for managers.

The Bloomberg Barclays EuroAgg Total Return index returned 2.92% annualized over a five-year period as of Oct. 31 and 2.51% annualized over a three-year period. By comparison, average Europe-domiciled bond funds' excess returns were at 13 basis points for a five-year period vs. 9 basis points of excess returns for a three-year period, according to Morningstar data.

In Europe, where 90% of fixed-income strategies are actively managed, money managers are also battling competitors for replacement mandates and are seeing a shrinking number of new traditional fixed-income mandates. Added to that, managers are feeling more pressure indirectly from requirements to disclose to investors the trading costs under Markets in Financial Instruments Directive II, a regulation that has favored managers that can charge lower fees because of their scale since its implementation in 2018, sources said.

Fixed-income managers agree that the overall fee pressure has trickled down to fixed-income asset classes.

"The fee pressure is affecting the entire ecosystem of managers," said Henrietta Pacquement, senior portfolio manager and head of investment grade for Wells Fargo Asset Management's European credit team in London, in a telephone interview, adding that the "low-yield environment is compounding" the pressure on fixed-income managers.

An asset owner survey published in October by consultant bfinance U.K. Ltd. showed 50% of 209 European investors have decreased manager fixed-income fee expenditure compared to three years ago. Net performance fees, which are more commonly found in Europe, have declined to 0.7% in 2018 from 1.7% in 2014, or at an compound annual rate of -20%. Net management fees are also down over the five-year period at an compound annual rate of -2% to 20.9 basis points in 2018 from 22.3 basis points in 2014, according to fee data for Europe-domiciled funds and mandates collected by management consultant McKinsey & Co.

"Investors bring the topic of fees more in conversations because they have nowhere else to go. So they are trying to put pressure on managers," said Christian Zahn, Frankfurt-based partner and European asset management practice leader at McKinsey.

And money managers operating in Europe admit to having to make reductions.

"We have had to reduce fees and it is hard to believe (other managers) did not have to," said Sarah McMullen, London-based head of Europe, Middle East and Africa client advisory group at PGIM Fixed Income, in a telephone interview. She declined to specify reductions.

PGIM Fixed Income managed $838 billion as of Sept. 30.

Mike Zelouf, director of European and Middle East business at Western Asset Management Co. LLC in London, concurred that European investors have used market power to ask for lower fees.

"They are filtering out managers based on price earlier in their selection process," he said.

Sources also agreed that a greater focus on fees from European regulators is making the pressure more acute. Regulators have required money managers to report expenses and trading costs to investors and their beneficiaries.

Christine Farquhar, London-based global head of the credit investment group at Cambridge Associates LLC, noted that due to negative yields, investors are pushing back on fees from managers.

Additionally, under Institutions for Occupational Retirement Provision Directive II, defined contribution plan sponsors in Europe are required to publish to participants information on costs, including manager fees in pension benefit statements.

Ms. Farquhar added that pension fund clients in the public sector are also under pressure to publish fees. "They are increasingly fee conscious," she said.

McKinsey's data also show that overall revenues for managers' European fixed-income investments have fallen 2% per year between 2015 and 2018. "We see signs of competition where bigger firms are trying to force fees down and put pressure on smaller firms," Mr. Zahn said.

Mathias Neidert, managing director and head of public markets research at bfinance in London, said: "The demand for fixed income is somewhat lower than it was in 2013."

Institutional AUM for all European fixed-income strategies has declined to $972 billion as of Sept. 30 from more than $1 trillion as of Dec. 31, 2017, according to data provider eVestment LLC.

Sources also said manager competition has increased, noting the impact of mergers such as Aberdeen Asset Management with Standard Life Investments in 2017 and Amundi with Pioneer Investments in 2016, which have helped these managers protect revenues and keep fees lower.

"Bigger players (are) now trying to use their economies of scale to undercut others on pricing," Mr. Neidert said.

To counteract declining revenues, managers are moving to add higher-fee strategies and restructure existing ones, sources said. "Managers increasingly open up private markets desks," Willis Towers Watson's Ms. Hollis said by way of example.

Cambridge Associates' Ms. Farquhar also said fee pressure on managers is resulting in some managers reducing spending on their credit analyst teams.

"In a recent example, the credit research team (at one manager) was reduced from eight to five analysts; in another, three portfolio managers were repurposed (into) more generalist PM/analyst roles, substituting for research departures," she said.

But managers are also investing in technology to be able to operate on a lower-fee basis.

"Managers that have invested heavily in technology and systems often require less human capital to manage active bond portfolios in future. This cuts costs and creates the potential for them to offer competitive management fees, below levels that may be possible without this infrastructure in place," said Mark Wilgar, investment director at Cambridge Associates in London.

PGIM's Ms. McMullen added that a drop in fixed-income fees could be most acutely seen in mandates where it is hard to determine alpha such as liability-driven investments or buy-and-maintain strategies.

Sources said investors have preferred buy-and-maintain credit mandates, which have helped to manage transaction costs but those sources also said trends vary from jurisdiction to jurisdiction.

"In the U.K., assets have been shifting from active to buy-and-maintain credit mandates," she said.

However, Ms. McMullen noted that buy-and-maintain credit mandates are low-cost alternatives to traditional fixed income rather than a solution for investors to a cost pressure. Buy-and-maintain managers have not been immune to fee pressure, she said, adding that these strategies have seen more pressure than others in fixed income.