‘Brave’; ‘innovative’; ‘alignment with client interests; ‘a response to Mifid II’; ‘greater transparency’; ‘a commitment to asset management’; ‘greater value for clients’ – these are just some of the claims and reactions to Fidelity International’s decision in October to ‘shake up’ the funds management industry by moving from a fixed-only to a base plus performance fee structure on its active management products.
But is this actually a sign of weakness from an industry heavyweight?
Dubbed a ‘fulcrum fee’, from Q1 2018 Fidelity proposes to introduce, on its equity products to begin with, a ‘symmetrically linked’ fee whereby a (lower) flat fee will rise or fall depending on whether performance is greater or lower than a benchmark over a three-year period, bounded by a cap and a floor. Simplicity was not one of the claims!
Led by Fidelity International chair Amy Johnson, the company lined up an impressive range of CEOs and CIOs in support of its assertions for the new fee structure.
‘Innovative’ is a bit of a stretch as Fidelity is not the first to make such a move – some years ago Orbis Investments moved from fixed to variable fees while giants such as Alliance Bernstein and Allianz Global Investors have something similar in part of their product range. Woodford’s Patient Capital Trust introduced an ‘innovative’ performance fee-only structure when it launched in 2015, while Vanguard, Putnam and Janus are just some of the names in the US that have been applying fulcrum fee structures.
A ‘better alignment of interests’ and ‘better value for clients’? Fidelity is proposing to lower the management fee by 10 basis points (bps) with a cap and floor of 20bps around this new base fee based on a 10% participation in performance above or below the benchmark. Blink and you might miss the variation in the ‘variable’ fee.
Could this baby step herald the ‘shake up’ some commentators predict?
Grab for attention by a newcomer
Some years ago I joined an asset management company that was transforming itself from a series of independent country operations providing captive clients with local-for-local products, into an integrated global asset manager with a third party institutional and funds offering. In effect a start-up, we had little credibility, lacking a proven investment proposition or an attractive long term track record.
Our CEO, supported by sales and marketing, considered bolstering the launch by offering performance fee-only mandates. This was discussed very seriously at the executive committee level. The marketing department even designed some draft promotional material which not only proclaimed the value for money and alignment of interests arguments, but also championed the offer as a statement of confidence in our investment management capability.
In fact it was quite the reverse – it was a grab for attention in a crowded market place by a newcomer that was yet to build a credible, globally integrated investment process and proposition. In the end, I and other investment heads argued against it for the very reason that credibility could only be earned by delivering and that buyers for active products were only interested in actual performance. Put another way, lowering costs will not save poor performers, while strong performers can charge high management fees supplemented by performance fees.
The controversial hot potato
Performance fees are in fact a controversial hot potato in the industry, susceptible to conflicts of interests and vulnerable to charges that they can dictate investment strategy if a performance fee is at risk or an underperformance penalty is looming. At the extreme, in the high fee hedge fund world, performance fees are an incentive to take super high risks with someone else’s capital in search of super high revenues for the manager.
Furthermore, far from providing transparency, financial advisers often bemoan the complexity of design and opacity that can come with performance fee structures. Typical criticisms include mystifying terminology, lack of any agreed industry standards, inappropriate benchmarks, poor disclosures, and designs that aim to maximise returns and minimise risks for the manager – an un-marshalled Wild West frontier.
The FCA, in its Market Study report earlier this year, joined in the criticism of the way some managers implement performance fees, lambasting the confusion they can create and challenging whether in practice they were really in the investors’ interest.
This challenge is backed up by a number of studies – and not just with respect to the well-known and almost obscene manager-biased outcomes in the hedge fund industry. A recent Morningstar study of actively managed funds with performance fee share classes found that the average expense ratio was similar to, and the average alpha below, that of flat fee funds.
Fidelity will be vulnerable to this charge because at the same time it announced the move to a fulcrum fee, it also disclosed that, with Mifid II imminent, they would be charging the cost of research to its clients, thereby reducing the lower flat fee benefit from its new structure.
In this context it is worth speculating about other factors behind Fidelity’s decision. Could it be a better business model?
Over the past 50 years the funds industry has been a highly attractive place in which to invest. The stars have been aligned – the longevity of an annuity stream of typically ad valorem revenues, earned without taking principal risk or needing to deploy significant capital, at a time when the demand for long term savings products has been, and will be, on the rise inexorably.
At one end of the business model spectrum there are those playing the long game, extracting value from the longevity of a scalable, predictable revenue stream with little capital deployment or capital at risk, as best exemplified by the passive/ institutional business.
At the other end there are those playing the short game in search of (super) high revenues from high performance by taking high risk, as best exemplified by the 2 and 20 hedge fund business. In between lies the majority of the active mutual funds industry taking low to modest risk with therefore only modest earnings expectations even with performance fees. Voluntarily lowering the predictability of your revenue stream in this middle ground, all other things being equal, immediately lowers the value of your business.
Surely this is something you would not do deliberately – unless you were very confident in your active performance. But therein lies the rub.
As I have said before in this column in response to the off-the-mark FCA Market Study, asset managers compete not on fees but on asset gathering and retention. In the active world this depends on performance, product quality and client service. You cannot earn credibility by changing your fee structure – you earn it by performing, delivering good products and servicing clients well. Far from a sign of confidence, adjusting fees is more a sign of weakness in some or all of these real differentiators.
A ‘brave’ step forward? With deep pockets and a large AUM base, Fidelity is in a reasonably safe position to adopt some uncertainty in its revenues. With the growing doubts around active management, Fidelity says it wants to respond to realities, in particular the pressure to justify fees and defend against the rise of passive management. However, the best (only) defence to these pressures is to strengthen performance and product quality – weakness in these areas cannot save the active manager however much they cut fees or align interests.
Fidelity seems to get this. At the same time as it announced its new active fee structure, it also promised more indexed products in the future. Another sign of confidence in its active capability?