“rethinking investment management fees”...source: publication - ‘poor charlie’s almanack’...

March 2019

“Rethinking investment management fees”Orbis Investments

Dan Brocklebank, CFA

2Source: Wikimedia Commons.

Delhi

3Source: Shutterstock.

4Source: Publication - ‘Poor Charlie’s Almanack’

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“Never, ever, think about something else when you should be thinking about the power of incentives.”

Charles T. Munger

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Revenues = AUM x Fee %

Assets under management (AUM).

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Revenues = AUM x Fee %

1. Don’t lose existing clients

2. Multiple fund launches

3. Increase sales force

Assets under management (AUM).

8Source: Gerhard Traschütz, National Guard photo by Master Sgt. Kurt Skoglund/Released

9Source: Shutterstock.

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1. How did we get here?

2. What are the problems we want to solve?

3. What might be the solution?

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But first…

…Some recent developments…

12Source: Cass Business School, City University London. Research sponsored by Orbis.

13Source: Cass Business School, City University London. Research sponsored by Orbis.

14Source: FCA Asset Management Market Study Interim Report S15/2.2, November 2016, p.93.

Disruption in fee structures: regulatory view

“The prevailing fee model incentivises firms to grow assets under management, which is not necessarily aligned with investors’ best interests”

15Source: UK FCA.

Disruption in fee structures: regulatory view

“There is substantial innovation in fund performance fees in the UK market at the moment, especially the development of more symmetrical performance fee models. These are fees that try to better align AFM and fund investors’ interests to the risks and reward of fund performance. For example, such structures reduce the fees payable to the AFM in the case of poor fund performance.”

16Source: Mercer.

Disruption in fee structures: consultant view

Under Mercer’s proposal, active fund managers would retain any additional gains they made from stockpicking only after they had delivered a guaranteed return plus a fixed annual fee that had been agreed with clients…

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Hedge fund actually refunds money when it misses benchmarks10 Sep 2015

A hedge-fund fee plan that only charges for alpha23 Apr 2018

Fidelity International to link fees to performance in overhaul3 Oct 2017

Zero fee future—is anything NOT going to zero fee in fund management? 28 Aug 2018

Innovative fee structures: industry view

18Source: Aquamarine Fund Thought Pieces, 30 August 2017.

19Source: GPIF.

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“GPIF fully appreciates that the new structure will have a big impact on the asset management sector as a whole”

Source: GPIF.

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1. How did we get here?

2. What are the problems we want to solve?

3. What might be the solution?

22Source: TopFoto.

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S&P 500 1965 - 1974

Source: Used with permission of Bloomberg Finance L.P.

48% decline

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FT 30 1965 - 1974

Source: Used with permission of Bloomberg Finance L.P.

73% decline

25Source: AW Jones Advisors.

26Source: Alamy.

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“It’s an obscene and usurious fee structure, but it’s the industry standard…anything out of the norm

and you waste half your time answering questions about your stupid-@*$ fees”

Whitney Tilson

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10%

20%

30%

40%

50%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

The latest mega-trend in investing:increasing flows into passive funds

Asia Europe United States

31 Dec 2018 | Source: Morningstar Direct Asset Flows.

29Source: CFA Society.

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Value for moneycan be measured by assessing what % of any outperformance your manager is taking in fees

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Client’s share of alpha = (𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 −𝑓𝑓𝑓𝑓𝑓𝑓𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎 𝑓𝑓𝑒𝑒𝑎𝑎𝑓𝑓𝑎𝑎𝑔𝑔𝑓𝑓𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎

)

Alpha = outperformance relative to a fund’s benchmark.

3%

3%

1%-66%

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Client’s share of alpha = (𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 −𝑓𝑓𝑓𝑓𝑓𝑓𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎 𝑓𝑓𝑒𝑒𝑎𝑎𝑓𝑓𝑎𝑎𝑔𝑔𝑓𝑓𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎

)

Alpha = outperformance relative to a fund’s benchmark.

1%

1%

0.75%-25%

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1. How did we get here?

2. What are the problems we want to solve?

3. What might be the solution?

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Flat Fees High watermark (‘HWM’) Fees

Calculation method % of AUM Base fee (% of AUM)+

Performance fee (% of value added)

High watermark? No Yes (typically!)

Also known as: Ad valorum Performance fees, “2&20”

Assets under management (AUM).

Some Definitions:

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321

Flat fees

Cumulativeoutperformance

generated bythe manager

Fees chargedas a % of

client’s assets

Manager deliversmarket return

Fee is stable

Manager addsvalue

Little reward

Manager destroysvalue

Little penalty

Valuefor money

The industry in aggregate

Source: Orbis. Illustrative only.

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• Simple to explain

• Easy to calculate and report

• Easy to compare across managers

• Easy for clients to predict costs

• Easy for managers to predict revenues

Flat fees:What are the benefits?

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Revenues = AUM x Fee %

Assets under management (AUM).

38Source: Gerhard Traschütz, National Guard photo by Master Sgt. Kurt Skoglund/Released. Alamy.

39Source: Alamy.

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2

What about HWM fees?

1

Cumulativeoutperformance

generated bythe manager

Fees chargedas a % of

client’s assetsReward

Valuefor money

Manager addsvalue

Note: Unless clients redeem exactly at the HWM point, the fee

structure is in practice better described as:

“2 and at least 20%”

Manager outperforms, then underperforms

Also reward!

Source: Orbis. Illustrative only. High watermark (HWM).

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• Some of the upside if they do well

• None of the risk if they do poorly

Under HWM fees, the manager shares:

High watermark (HWM).

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“Sequencing Risk” is the risk that clients pay different

levels of fees for the same amount of gross performance due to differences

in the paths taken to generate that performance.

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Sequencing risk in practice (HWM)

Cumulativeoutperformance

generated bythe manager

?Valuefor money

Source: Orbis. Illustrative only.

Fees chargedas a % of

client’s assets

1 2

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HWM fees: what are incentives for managers?

1. Don’t grow AUM too much

2. Outperform…

3. …by ratcheting up risk if necessary

Assets under management (AUM).

45Source: Gerhard Traschütz, National Guard photo by Master Sgt. Kurt Skoglund/Released. Shutterstock.

46Source: Shutterstock.

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So, what are the problems we want to solve?1.Remove the incentive for managers simply to gather assets;

2.Link incentives to key client objective (i.e. l-term performance);

3.While avoiding incentivizing excessive risk taking;

4.Make sure the path of performance doesn’t matter; and

5.Offer value for money in periods of low performance.

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1. How did we get here?

2. What are the problems we want to solve?

3. What might be the solution?

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There is no silver bullet

Source: Shutterstock.

50Source: Financial Times.

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Benchmark

Value deliveredto the client

Manager’s shareof value added

Fund

2. Client invests 3. Client redeems

1. Client and manager agree up-front how to split future outperformance

4. Outperformance is split in the

pre-agreed ratio

A theoretically ‘ideal’ fee structure?

Source: Orbis. Illustrative only.

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So, would this solve our problems?1.Remove the incentive for managers simply to gather assets;

2.Link incentives to key client objective (i.e. l-term performance);

3.While avoiding incentivizing excessive risk taking;

4.Make sure that the path of performance doesn’t matter; and

5.Offer value for money in periods of low performance.

?

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“The base fee rate has been drastically reduced to the rate of passive fund for institutional separate account.”

“The maximum (performance) fee rate is scrapped.”

“Introduction of a carryover”

GPIF’s solution

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Client ManagerFee Reserve

A Refundable Fee Mechanism

B. If the manager subsequently underperforms, fees are refunded to the client from the reserve

A. If the manager outperforms, the client pays performance fees into the reserve

C. When the reserve reaches a certain level, fees flow from it to the manager at a capped rate

CA

B

A

Source: Orbis. Illustrative only.

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Concluding remarks…

56Source: Shutterstock.

57

10%

20%

30%

40%

50%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

The passive trend is real and is driving focus on Value for Money

Asia Europe United States

31 Dec 2018 | Source: Morningstar Direct Asset Flows.

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Suggestions: steps you can take1. Ask managers to report on their value for money—

the share of alpha they’ve taken in fees2. Look for fee structures that tie the manager’s

interests to yours or ask managers to do this3. Ask managers about the incentives and risks created

by their fee structures4. Focus on maximising net returns rather than

minimising fees

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Useful linksAquamarine Fund – “Zero management fees – a survey”

Bloomberg – “A hedge-fund fee plan that only charges for alpha”

Cass Business School – “Heads we win, tails you lose”

FT – “Fidelity International to link fees to performance in overhaul”

GPIF – “GPIF’s new performance-based fee structure”

Time – “Hedge fund actually refunds money when it misses benchmarks”

Our thoughtsThe Association of Canadian Pension Management – “Rethinking investment fees”

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Ask us

Dan Brocklebank

@OrbisDanB

@OrbisInsights

Orbis Investments

www.orbis.com

Chris Horwood Dan Brocklebank