The debate around how fund managers’ pay incentives should work has been reignited.
Firms have started to introduce new cost structures in an attempt to improve transparency, as the FCA steps up its focus on how asset managers assess their value. The companies that have already introduced new fee models claim it will not change the way they pay fund managers.
With this in mind, Money Marketing asks companies that have introduced new fee models how they plan to align their interests with those of their clients, and as passive providers continue to grow their market share, we look into how their fund managers are paid.
Several fund groups have been lowering and tweaking their fees and charging models in recent months, claiming that this was a move to more “investor-friendly” pay structures.
However, there is still a lack of clarity as to what extent the fund performance is borne out in pay packets.
Fidelity International, which has recently added a performance fee to some funds, says fund managers are paid a basic salary with the potential for a bonus based on the performance of their funds over three and five years. An assessment of the level of risk taken is also a factor.
With its new fee model, called a fulcrum fee, Fidelity will charge a higher fee when it delivers outperformance net of fees, but will be lower if performance meets or is below the benchmark.
But a spokesman for the firm says the fulcrum fee would not affect the way Fidelity rewards its fund managers: “The variable management fee is focused on aligning our pricing to client outcomes.”
Because the fee acts as a two-way sharing of risk, Fidelity says this will align the overall profits of the company and those of their clients’ portfolios more closely.
This month, Allianz Global Investors also launched a performance fee structure on five of its UK funds whereby if a fund underperforms, a client will only pay a fixed fee of 20 basis points.
If it beats the benchmark by an unspecified amount, the client will pay an additional fee of 20 per cent of the outperformance.
Allianz GI chief executive and chief investment officer Andreas Utermann says this will not change the way the firm rewards its fund managers. On top of the basic salary, the variable pay will remain on a discretionary basis, which is common in asset management.
US manager AllianceBernstein also plans to roll out a new performance-linked fee structure in continental Europe, according to reports.
An AllianceBernstein spokeswoman says the firm does not expect a shift in pay structure either.
She says: “Fund manager compensation is determined by a range of metrics, including company profit, investment performance – primarily over three to five years on a risk-adjusted basis – of the portfolio manager’s team and the individual funds they manage, as well as various non-financial factors.”
At Orbis Investments, which has been using a performance fee model for nearly 30 years, all employees receive a salary and a discretionary bonus. A long-term incentive plan is available to some staff members, and only “skilled” ones could be entitled to a share of the company’s profits.
In some cases, if a manager at Orbis underperforms, they may not receive any bonus at all.
Orbis Investments director Dan Brocklebank says: “At each compensation review, performance is always reviewed on a cumulative basis over the maximum timeframe possible to ensure that when assessed over the long term, compensation levels for any individual manager have been commensurate with their contribution over time.”
The passive reward
Passive fund managers are usually paid by how closely they get to tracking an index. The value of the tracking error is different from region to region, as Vanguard head of product for Europe Matt Piro explains.
For large-caps in the UK, the tracking error is expected to be lower than that of a global corporate fixed income strategy, for example.
Piro says the fund house’s incentive structures are measured through a blend of criteria.
He says: “A team-based approach is important in the passive space, especially when managing funds globally. On the quantitative side, it is all about the closeness of tracking the index. If you outperform, incentives go up and it depends on the overall portfolio delivery and the result of the team.”
Contrary to most active but also some passive fund houses, Vanguard’s asset growth is not linked to managers’ pay.
Although it is mainly a passive manager in the UK, Vanguard has recently launched a number of active funds, which are sub-advised to external managers and supported by Vanguard’s analysts.
The pay structures with sub-advisers are individually arranged.
When advisers outperform over a minimum of three years, they are able to earn an incentive but if they underperform they do earn less, and a “performance penalty” is applied on their fee, says Piro.
Fundhouse investment director Andrew MacFarlane says payment structures in the passive space are more transparent than in other business models.
He says: “What I like about passives is that everyone is competing to get as close to something as possible and it is quite clear.
“For Vanguard, it is like working at a retailer, so they keep costs down. But [passive managers] will reach a point where unless you are a shareholder of the business, it is going to be difficult to earn extreme amounts.
“In the active space, on the other hand, if you deliver exceptional performance, you are going to be rewarded with exceptional pay.”
Psigma head of investment strategy Rory McPherson says tracking risk is not the only good measure for passive managers. He argues that liquidity and replication costs need to be taken into account, depending on the nature of the benchmark.
Overall, McPherson says the incentive-based pay should be benchmarked on the metric that the manager is meant to outperform.
He says: “This helps ensure that, not only are their incentives aligned with their clients’, but the client doesn’t have to worry about style drift as the pay and incentive structure is keeping the manager honest to the mandate they have been tasked with running.”
In the future, he says risk-adjusted outperformance will be a key focus for appraising managers, especially for funds with a higher active share.
Where is the value?
With more fund managers charging a performance fee, MacFarlane says a greater focus will be paid on performance rather than asset growth, provided this is measured on a long-term basis.
But AJ Bell head of fund selection Ryan Hughes suggests there should be a cap on what fund managers can earn as a percentage of the fund, especially when performance fees are applied to very large funds.
Hughes recently examined the £10.9bn ($15bn) Old Mutual Global Equity Absolute Return fund which charges 1.65 per cent performance fee, meaning it made roughly £247m in fees over 2017 because of its considerable size.
He says: “We tell clients to invest long term and then we bombard them with one-year performance numbers. We pay our managers based on one-year performance and the smart ones also negotiate a revenue share.
“If they get 50 per cent of the revenue, in some instances the pay goes up substantially even if the reward for the customers is not going up.”
Hughes says fund manager tenure is also getting shorter, which means “the reward failure is still too high”.
He says: “Fees are on their way down but whether that filters through the manager pay I don’t know. But ultimately there are going to be fewer products – bad ones will be merged away – so bizarrely over time the average earning might increase because you don’t have a tail of bad funds. It won’t take too many disenchanted fund managers taking assets with them and setting up their own shop.”
Blue Whale chief investment officer Stephen Yiu set up the boutique firm with Peter Hargreaves after leaving larger asset management firms such as Artemis.
Yiu argues the reason why groups such as Fidelity came up with a new fee structure is that most funds usually underperform the benchmark.
He says: “We charge a flat fee but because we run a highly concentrated fund we do a lot of work in-house and if we get it right we outperform significantly but if we get it wrong we’ll underperform significantly. But for an asset gatherer managing billions if they use our approach and they underperform, they’ll lose money.”
Yiu declined to comment on how the boutique firm rewards its fund managers.
In its final report into the asset management industry, published in July, the FCA said it is “supportive” of fee structures that align incentives between investors and asset managers, but for now, it won’t rule out anything when this fails to happen.
On assessing value from the FCA, Allianz GI’s Utermann says: “When it comes to savings, value is a concept that is not clearly definable.
“It will depend on the price you get, on performance or if systems are good or not. There is too much emphasis on this and that can be counterproductive. There is a balance to be found.”
Historically, the standard way of rewarding fund managers is based on generating positive investment returns against a peer group or benchmark. However, more recently some firms have tried to link reward to the commercial aspects of products such as profitability.
On top of this, pay regulation has introduced the concept of looking not just at what is delivered, but how – incorporating factors such as teamwork, good behaviour, and risk and compliance standards.
With performance fee-based funds, the principle of sharing in these fees by fund management teams is not new. This began in the world of hedge fund and private equity boutiques, where management fees were charged to cover costs and it was only if there was upside in performance delivered to investors that managers were paid a material bonus through a share in the performance fee.
Many of these firms are owner-managed, however the fee-sharing practice has translated to similar funds run by more institutional managers.
There has been a downward trend in the proportion of the fees shared with the teams and these are also often shared across a broader range of employees.
These arrangements are often coupled with an opportunity to participate in other bonus pools depending on what else managers are being asked to do. Any businesses looking to remove the concept of sharing performance fees with fund teams typically need strong justification given it is such a well-established market approach.
There is a sense that pay structures in asset management are changing. Many are now asking: “Is our approach fit for purpose?”. We expect something of a revolution in pay models, following the period of stagnation in innovative design coming off the back of aftermath of the financial crisis.
However, the fantastic growth outlook for the industry suggests that pay inflation may continue, with headwinds of regulation combined with greater external scrutiny, firms may need to differentiate using innovative design rather than relying on the highest bid.
If you recognise the manager is good you are in a stronger position in terms of pay but it is different if you are part of a team. We have seen many managers benefiting from the share of the assets and performance of a fund but this will change through time. One reason is regulation and then over the years we’ll also see less focus on the concept of a star fund manager and there are not many star mangers left anyway. With far greater transparency, remuneration policies will be highlighted more and you’ll have more transparent structures and they will be more focused on the base salary than the variable pay but this will not happen overnight.