Opinion: Questions I’ve Always Wanted To Ask An Investment Manager

Authored By: James C. L. Clark | Publish Date: 10/16/2017

I have been involved in institutional investment management for pension and related funds in Canada for over 25 years and I have always wondered about the fee model that is used for portfolio management services.

In general, investment managers will charge a fee that is expressed as a percentage of the market value of the assets under management. These fees can range from a few basis points for index products to up to one per cent for investments such as emerging market equities. While there are more innovative fee structures for alternative or non-traditional investments, with the inclusion of hurdle rates and performance fees, my questions focus on the traditional long-only portfolios.

As a simple working example, let us consider a mythical firm, ‘MONEYCO,’ that manages $1 billion in balanced mandates (including Canadian and non-Canadian equites, fixed income securities, and cash) for a blended fee of 30 bps per annum based on the market value of the assets under management. This firm will have total revenue of $3 million.

What are the primary costs for MONEYCO? A review of the financial statements of a publically traded investment management firm shows that the cost structure is fairly simple. The major expenses are selling, general, and administration costs (SG&A) and this includes such things as employee costs, travel and marketing, rent, technical services, professional fees, and ‒ the catch-all – other. Most of these costs do not vary directly in line with the growth in assets under management (AUM). If the assets double, it is unlikely that the cost of rent, technical services, and professional fees will double. The employee costs, which can represent 70 to 80 per cent of total SG&A expenses, would include base salaries, benefits, and bonuses. Again, if they are actually employee costs, they should not double just because the AUM doubles.

As such, MONEYCO will have revenue linked to AUM and costs that are predominantly fixed or marginally variable. What I’d like to know is:

  • What happens when a new client comes in?

If MONEYCO gains a new mandate for $100 million, revenue will increase by $300,000, but what is the impact on its costs? Other than the potential to pay sales commission and some minor impact on the travel and marketing costs, the portfolio management team should be able to absorb an additional 10 per cent of AUM with very little incremental cost.

  • What happens when markets rise?

Now let’s consider the situation where the team at MONEYCO generate a five per cent return on its balanced fund for 2016. The revenue of the firm would increase by $150,000. Assuming a Canadian inflation rate of less than two per cent, this means that its real revenue has increased by $90,000. But does it take any more resources to manage that portfolio? If the benefit of the real growth in revenue flows to the bottom line, this may be acceptable if the manager has ‘added value’ for the clients.

Now let us consider the issue of value added! If the reference portfolio generated a return of less than five per cent, then the incremental real revenue may be justified. But what about the situation where the benchmark return is equal to or greater than five per cent? Why should the team at MONEYCO receive any greater fee? They have failed to do their job, but there is no mechanism to stop their fee from increasing.

  • Why do clients not demand performance-based fees?

The obvious solution is to switch to a world of performance-based fees so the team at MONEYCO would earn real increases in revenue if and when they outperformed appropriate benchmark portfolios. The switch has not happened and there could be a number of reasons for this:

  • The clients are concerned that the manager will take additional risk if they need to earn a performance fee. This is not a real issue as risk can be controlled in many ways and any manager who tried this strategy should be terminated immediately.
  • The complexity factor increases as there are many ways in which performance fees can be calculated, but this is no different than the issues that arise in setting any compensation arrangement.
  • There is a power imbalance between the investment managers and the clients under which the client generally does not have the leverage to force the manager to adopt a performance fee arrangement.
  • For a pension manager who genuinely believes that they are excellent at picking investment managers, they would end up paying higher overall fees because their ‘good’ managers would consistently earn performance bonuses!

In my opinion, none of these arguments should prevent the development of an appropriate performance-based fee model.

On a related question, it is interesting that the consulting community is not pushing harder for fees that reward managers for good performance. I may be a cynic, but I could suggest one reason. With a couple of notable exceptions, the consulting community wants to get into the Outsourced CIO business and that is usually priced using a AUM-based fee. For the same reasons the managers like AUM-based fees, the consultants want to get away from project-based fees or annual retainers that are fixed.

My Suggestion

If AUM-based fees are so good for paying the investment managers, why not ask for an AUM-based salary? Should the CEOs of the major pensions be paid based on a percentage of the assets of the fund they manage? In fact, I could think of all sorts of ways they could work – CEOs paid on the basis of corporate net assets; politicians paid on GDP.

To put it another way, asset owners should be pushing for pricing that reflects the manager’s cost of doing business and a fee that rewards ‘good’ performance – not just any positive performance.

James C. L. Clark (CPA, CA, CFA) is president of Dunhelm Consulting Inc.

james@dunhelm.ca


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