Paul Trickett, European head of Investment Consulting at Watson Wyatt, said: "One of the main reasons for this upward cost spiral is investors' focus on 'alpha', which has increased their appetite for alternative assets. Investors have naturally assumed that they are paying these fees to reward manager skill, but in many cases they are wrong."
In a research note entitled 'A fairer deal on fees', the firm says that many pension funds have been paying 'alpha' fees for 'beta' performance because the main driver of returns in recent years has been the strength of the markets. This has encouraged investment managers to leverage their portfolios to boost returns, which means that investors are often paying for leveraged beta (market returns multiplied by gearing).
Paul Trickett said: "This is obviously a good deal for investment managers, but not necessarily for their investors. While we strongly believe managers should be fairly compensated, fees are currently too high for the value they deliver particularly as we enter a lower-return environment. Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in managers' favour."
In the note the firm identifies a number of flaws in investment manager fees, including:
- Base fees are currently generally calculated on an ad valorem basis which encourages asset gathering and can harm performance
- Annual performance fees can amount to a free option for the manager, as the upside is uncapped but the downside is limited to the base fee
- Fees can also be paid on money waiting in cash to be drawn down for investment
- Many leveraged real estate managers charge fees on the gross exposure rather than committed capital
- Fees charged by fund of funds can use a combination of these flawed approaches and in many instances lack transparency
Paul Trickett said: "In the recent past, many trustees have unwittingly paid away the vast majority of their 'alpha' in fees, surprisingly even when their fund managers have performed particularly well."
According to the firm an ideal fee structure should have a low base fee to cover costs and a performance fee which should be calculated over longer periods (typically three to five years), include 'ghost' years and have hurdles and high-water marks. In addition, total fees should never be more than 50 percent of alpha and costs should formally be included in funds' risk budgets. It also says that fee structures should not be standardised across the industry in view of the increasing diversity of investment strategies and mandates.
Paul Trickett said: "This is a complex area, which doesn't mean it should be glossed over as too much value has already been allowed to leak away. There are signs of change as we move into a different market environment where many managers will no longer be able to justify their charges without beta to bail them out. In future, active managers that wish to win pension fund money will need to offer them a fairer deal."
