As more and more investors consider passive investing (and therefore lower management fees), the question whether active funds managers can stop this migration to passive funds looms large on the horizon. As alluded to by the Financial Times in one of its recent articles, a potential solution lies in a shift towards performance fees.
In the US, only 4% of assets in mutual funds are managed through performance fees. Performance fees are considered to be a motivational force for the asset manager: the better he performs, the more he earns. It also allows asset managers to demonstrate their value to their clients. Furthermore, the client will only pay for a service that has proven to be effective. Everybody wins.
The last season of quarterly earnings in the US illustrates the need to cut active management fees and to shift towards passive management. Some fund management firms have experienced the wind of change firsthand and have started adapting. Alliance Bernstein launched the “AB performance fee series” for 6 mutual funds for which the investor will only be charged 0.05% unless the asset manager beat the index by a decent amount. In that case, performance fees could go up to 1.45%.
In the US, performance fees seem to be the solution for asset managers to keep their customers.
On the contrary, performance fees don’t seem to have the same success in Europe. The European Commission and the Parliament considered banning them a few years ago and in its report on the Asset Management Market Study published last June, the FCA (Financial Conduct Authority) raised the notion that there is no solid evidence suggesting that performance fees would improve the performance of fund managers. The authority recognizes however that performance fees are simply fairer and that if the asset manager makes a mistake, investors won’t pay for it.
In its report, the FCA mentions the difference between incentive structures based on symmetric (a performance fee where the manager shares some portion of both the up and downside of fund performance) and asymmetric (consisting of a fixed base fee as a proportion of assets under management as well as performance fee consisting of a set portion of the upside performance) performance fee models. The FCA highlights the fact that the current legislation does not exactly prescribe which operation models the AFM may or may not use. The FCA specifies that the fee must not be unfair to unitholders or materially prejudice their interests and mentions that they have found that some AFMs charge fees for achieving a level of return below the most ambitious target they hold out to investors, for example in absolute return funds.
The British watchdog supports fee structures that align incentives between investors and asset managers and is considering looking into rules so that performances fees are only permitted above the fund’s most ambitious target. The FCA also underlined in its report that some performance fees were charged on gross returns (before ongoing charges) and will therefore consider whether these performance fees should only be permitted above the fund’s most ambitious target after ongoing fees.
Read the FCA report on asset management 2017 here
Read the Financial Times article here
Read more on Symmetric and Asymmetric incentive fees here