Are performance fees justified?
Should investment management firms be paid according to the size of the account they manage? Or according to the investment results they achieve? This issue is surfacing more and more in the dealings between corporate executives and portfolio managers. It is exacerbated by the increasingly large funds that are being managed.
At the recent annual conference of FEI's Committee on the Investment of Employee Benefit Assets, corporate spokesmen and investment managers took up each side of the issue. We present here the outspoken views of two of the participants. Given the increasing debate on how various fees are calculated, some of the comments may also have an application beyond the parameters of corporate pension fund managers.
We announced to our 24 domestic equity managers in the last quarter of 1987 that it was going to be our policy to deal only with those who would accept a performance base fee. I'm pleased to say that all 24 have agreed. However, there were only a handful who were really enthusiastic about the program, considering it an opportunity to make more money. Most seemed resigned, offering no resistance, while six or eight were dragged kicking and screaming into the program.
Why did we decide to introduce performance-based fees at GTE? To answer that, I have to go back to the independent investment firms that came into the field in the late '60s and early '70s. It was not unusual in their business presentations for these new firms to promise a return of 600 to 800 basis points over the S&P 500, since they did not really have a track record. So fees rapidly went up from the roughly 30 basis points banks had been paying to 60, 80, and 100 basis points. And sponsors were willing to pay those higher fees because their expectations were raised. If you're going to get 500 basis points over the market, you've no problem paying 1 percent of market value in fees. Fees become immaterial.
However, the reality today is that about two-thirds of investment managers do not beat the S&P 500. So, the conclusion has to be that, in general, most firms underperform the market, while fees have gone up dramatically.
In fact, fees have doubled over the last five years because assets have doubled. But how many managers have produced value added to their clients along with the increased fees? I don't think the majority have. So, this seems to us to be a fairness issue. We think that fairness has to be part of the formula in how we compensate investment managers for what they're doing. We want to pay for the results we get. And we're not talking about something that's very difficult to analyze and come to an agreement about. They're very quantifiable results. We're not talking about an incentive issue here. I think that profit margins are incentive enough. The nature of the business produces enough incentive.
There are those who say that if managers are put on performance fees, they'll take more risks. But we all monitor each of the portfolios that we have our own program. We know the characteristics of each portfolio relative to the other discretionary portfolios that a manager has. If we see a deviation because the manager is treating our portfolio differently, we simply fire the manager, because then he is making a business decision, not an investment decision. So I don't think risk is really a problem.
There are those who say you can always fire a manager, and that's the ultimate performance fee. It's true that you can fire a manager after five or 10 years of poor performance, but to pay him a full fee during that period does not seem right. Yes, he loses your business, but he has banked an awful lot of money while producing nothing of value.
Certainly, if performance fees become a norm, it's going to change the way investment management firms operate their business. It's going to create unpredictability with respect to future earnings and cash flow. Well, everyone in business has unpredictable cash flow and unpredictable earnings. Why should investment management firms be any different? Welcome to the real world of American business.
Inefficiencies in this business have to be addressed. And plan owners such as GTE have a fiduciary responsibility to address them because the fees that we pay come out of the trust that we're responsible for as fiduciaries. It seems to me irresponsible to continue to pay for services not rendered.
The workings of GTE's plan
How does our performance fee program operate? The building block is the normal portfolio based on the investment manager's style. Each manager has a style that is like a fingerprint. It's distinctive and usually can be accurately classified.
In fact, most every manager can be classified with a normal portfolio of 600 to 800 stocks that replicate that manager's style, in terms of capitalization, price to book, PE ratio, yield, and the like. Presently, all 24 of GTE's managers have signed off on a normal portfolio saying, "Yes, that is our specific style, and we're willing to establish our future fees relative to that basic benchmark." Where a manager has an electric or non-definable style, the S&P 500 becomes the manager's "normal."
The base rate we use is the manager's full fee, but in order to earn that full fee the manager must perform a fee-adjusted 200 basis points over the benchmark. Why 2 percent? Years ago, the promises were up around 6 or 8 percent. Well, now they're down to 2 or 3 percent. I think it's interesting to ask a prospective manager during his presentation what his expectation is in terms of future performance over a benchmark he finds appropriate. I have never heard a manager say less than 2 percent, because he knows if he says less you're not going to take the risk of active management and high fees. So 2 percent is the implicit promise when you hire most managers. It's often more. His standard fee should be geared to that expectation.
We also insist that the manager overcome his fee in addition to the normal 200-basis-point floor. And the reason we do this is because fees vary considerably for the same kind of service. So in order for a manager to earn his normal fee, he's got to do 200 basis points over his benchmark, plus his fee. Then we will pay him up to 200 percent of his basic fee if he performs well, while we will never pay him less than 25 percent if he does poorly. We have a 25-percent floor because we know there are costs in this business, and we want him to at least be able to pay his overhead. Our performance fee is on a rolling three-year basis, to be settled up at the end of each year. During the year, the manager is paid a quarterly fee based on the 25 percent of normal fee minimum.
For example, take a manager whose basic fee is 50 basis points. In order for that manager to earn that fee, he must perform 250 basis points over his normal portfolio. He can double his fee if he performs. 500 basis points over the normal, while he will get the minimum if he does 500 basis points under the normal. In between is a sliding range that is a little more generous on the upside than on the downside.
We put a pilot program into effect in 1987 for three investment managers. At the end of the year, one of those three managers had performed 500 basis points over the market, and we were absolutely delighted to double his fee. Because my compensation is related to the performance of the fund, I personally was also very happy to pay that amount.
The other two managers, on the other hand, produced performance about 500 basis points below the market. They received a quarter of their fee. They didn't help us at all last year. The bottom line was that for a relatively modest experimental program, we saved about $250,000 in fees last year. But I think what is more important is that we rewarded the manager who did well, and gave him a large bonus, while the two organizations that did poorly received considerably less than their standard fee.
To sum up, it's my contention that we shouldn't have to pay active management fees for an investment style that we can purchase at a very low cost through a passive, "normal" portfolio. Active management fees should be paid when a manager adds sufficient stock selection performance over a normal, passive portfolio to warrant that kind of compensation.
Opinion is sharply divided on the merits of performance-based fees. Where one comes down on this issue has less to do with the intellectual merits of the case than with the vested interests at stake. No matter how the basic arguments are "dressed up," most plan sponsors who favor a fundamental restructuring of investment management fees expect a net reduction in actual fee outlays. Money management firms are generally against performance-related fees because they are exposed to significant business risks if a substantial portion of their fee revenues is variable. We believe that performance fees are a bad business practice and constitute an ongoing threat to the survival of our company.
Many of the performance-related fee proposals I've seen have one thing in common: they presume that the existing fee schedule already agreed to will continue in force. However, the plan sponsor proposes to amend this document, so that the manager will receive the stated fee only if he achieves a stipulated performance minimum that is tied to a specified benchmark. The manager is required to "give back" part of his fee to the degree he underperforms his benchmark.
We have established a mutually agreed-upon fee schedule with our clients. We make no promises, either implied or expressed, beyond our "best efforts." And we receive a specified fee no matter what the results.
A client who reduces this contracted fee if we don't achieve specific performance minimums is making the fee contingent. What that client seeks is really a type of "insurance policy" wherein the manager will refund (via a fee giveback) some portion of any performance shortfall (the casualty loss).
I conclude that any manager who agrees to modify his fee schedule in the above manner should first raise his basic fees--because superimposing performance minimums on existing fee schedules without such features constitutes a de facto fee reduction.
A more radical fee approach would scrap existing fee arrangements and substitute in their place a very low base fee (e.g., 15 basis points), plus incentives related to a portfolio performance in excess of some benchmark. This is a stratagem to lower fees, since a manager's gross fees could be reduced as much as 50 percent if portfolio performance merely equaled market results.
In this instance, the client gets a very large cake and gets to eat it, too. This is because the sponsor is agreeing to pay active managers (with high fixed costs) a very low base fee, similar to what a low-cost, passive index manager might charge. The sponsor gets to select the very best active managers in the country and pays passive fees during periods when a manager doesn't outperform the market; he only pays more when active management works. This sponsor is in a win/win situation!
Another performance fee variation is that a manager must equal the S&P 500 return plus 150 basis points in order to earn his standard fee. He gives back 10 basis points of his fee for each 50 basis points he falls short of this target. Thus, he would give back 30 basis points of his fee if he only equals the S&P 500 return in any given year. An important feature is that a manager would never receive less than one-half his fee no matter how poorly he does, although any shortfall would be carried forward and applied to future fee determinations.
Although aggregate manager revenue may be large, the average fee (in basis points) is modest in a relative sense. Ten-basis-point fee decrements tied to 50-basis-point increment shortfalls from the S&P 500 return might constitute as much as one-half or more of the price of the product. I believe that any investment manager who agrees to fees that are contingent on performance minimums without calculating the insurance cost to him in terms of business survival, and adjusting his standard fee schedule accordingly, is naive.
The money manager pendulum
One of my principle jobs is to keep my firm financially strong. But financial strength can be eroded by performance-related fees. It is accepted that certain investment styles will alternately bask in market favor and fall from grace because of underlying economic and market cycles. Growth stock managers, for example, fared poorly from 1973 to mid 1978.
This raises a pragmatic concern. Presume a manager experiences a three-year period during which he underperforms the market because his style is out of "sync," not because of poor stock picking or other problems. Ongoing fees would be lowered accordingly. But, theoretically, the manager will be able to recoup these penalties when the market again favors his style. However, it is quite plausible that the client's investment committee would discharge the manager before market sentiment shifted in his favor.
What is the possible effect on the professional staff of the manager during such a period? The worst scenario occurs when a firm underperforms its benchmark at the same time the stock market declines. A fee giveback for poor relative performance when combined with a lower asset base can push revenues below fixed costs (rent, salary, taxes, computers, accounting and report preparation, and the like).
Very few money manager firms retain a cash buffer for rainy days. The first result devolving from the above scenario is a likely salary freeze, generalized cost cutting, and a selective reduction in headcount. The more desirable professionals don't wait around to see if the "other shoe will drop." Their resumes are in the mail. And soon the entire organization has lost its special mystique, temptations arise to alter the investment style, and all-consuming attention must be devoted to surviving, not client performance.
Frankly, I am puzzled by the interest in performance-related fee arrangements. Our fees are our wages, and I know of no better way to create an ongoing adversarial relationship between manager and client than to continually attempt to quantify how much current services rendered are worth. Our fees are fair, and we shouldn't be penalized if the fruits of our labor at some future point aren't as bountiful as we would like. In the short-run, we should be paid for our efforts, not our performance results. In the long-run, if the results don't accord with the efforts, the best solution is to end the relationship.
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|Title Annotation:||pro and con|
|Date:||May 1, 1989|
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