Daniel Brocklebank, CFA, had a warning for the audience at the 72nd CFA Institute Annual Conference: Bad incentives lead to bad results. In investment management, compounding bad results can be catastrophic.
Brocklebank, who is UK director of Orbis Investments, began his presentation by telling the story of the cobra effect. It’s a lesson in policy gone wrong, where a reward placed on dead cobras drove people to breed venomous snakes for profit. The moral is that people respond to incentives.
With that in mind, he suggested that it was worth considering the incentives affecting asset manager behavior.
Manager fees based on assets under management (AUM) are convenient for many reasons. They’re simple to explain, easy to compare across managers, and predictable not only for clients tracking costs, but also for managers planning revenues. However, they come with problematic incentives.
Although clients want to maximize their net-of-fee returns, AUM-based fees encourage managers to allocate their firms’ resources to areas that are less directly focused on generating those returns. They bring incentives to diversify into larger numbers of fund strategies, building a bigger sales force to market products and attract new clients. And managers become less willing to deviate from benchmarks, because they’re afraid to take risks that could drive their current investors away.
“We’re not emphasizing the outcomes that clients seek,” Brocklebank said. He cited a study from Cass Business School showing that the most prevalent fee structure in the UK market is generally the best for the manager and the worst for the investor.
In the United State, Fidelity now offers funds that don’t charge any fees based on AUM, and Vanguard has made headlines with its response. This race to zero may lead to a series of unintended consequences, and Brocklebank isn’t sure that it’s the answer. “I’m not advocating that overnight everyone should suddenly have zero base fee models,” he said. “The solution should not be everyone on zero-based fees.”
Finding a suitable replacement for AUM-based fees poses its own challenges. “We, as an industry, run the risk of perpetuating a modern-day cobra problem,” Brocklebank said.
The classic “2 and 20” fee model has considerable drawbacks as well. It places less emphasis on growing AUM, but Brocklebank explained that it can encourage managers to take excessive risks with client portfolios. They end up sharing some of the upside in years of outperformance and none of the risk when they do poorly.
“The core elements are that we need to embed value for money by tying fees to results generated and avoiding swapping one set of incentives for another,” he said.
CFA Society of the UK, which hosted the conference, has released its own framework for assessing the value delivered by investment managers. Although Brocklebank said that he was delighted to see the society’s efforts, he warned that it’s easy to over-complicate things.
For Brocklebank, the ideal fee structure aligns interests, maximizes long-term performance, and offers no incentive to take inappropriate risks. But a long-term focus makes it difficult for investment managers to claim their fees in the present day. “The manager needs to get paid along the way. It’s to keep the lights on,” he said. His own firm uses a refundable fee model in an effort to link its compensation to the results that it delivers.
Some asset owners have taken their own steps to re-align the incentives of their investment managers. Japan’s Government Pension Investment Fund (GPIF), the largest pension fund in the world, unveiled changes to its performance-based fee structure last year. Brocklebank suggested that this change, designed to promote long-term investment, was relevant for the entire industry. “Maybe, just maybe, it’s worth paying attention,” he said.
There is no one-size-fits all approach to investment management fees, because each investor’s concerns are specific to their current circumstances and future requirements. A complete set of tools, and an awareness of its limitations, is needed to influence investment manager behavior. Brocklebank’s presentation was a useful addition to that toolbox.
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Image courtesy of Neil Walker