Change fund manager payment to burst bubbles and hit herding hard
HOW should we pay fund managers? At present we pay them too much to do the wrong things. But even the least charitable observers must accept that it is difficult to move them to a more rational system.
This is not just because nobody likes a pay cut, and there is more to the issue than competition for talent.
The critical problem is that a new way of levying fees involves huge risks for fund managers.
But many are trying to solve the problem and, with luck, one of the solutions being tried out will work.
Fees are too high. The chunk taken by active managers was set in an era when stock returns were far higher than they are likely to be in the future, before cheap indextracking funds, and can no longer be justified.
But the deeper problem concerns incentives. By paying a management fee as a proportion of assets under management, we pay managers to accumulate assets, not to beat the market.
Like everyone else, they do what they are paid to do, and manage their assets so as to minimise the risk of clients pulling out their assets — and this leads them to herd together.
There is safety in numbers. Invest in the same thing as everyone else, and the risk falls that you do far worse than them, triggering outflows.
Take a big contrarian bet, and you risk looking bad and losing money, while if you do well pension consultants might well tell their clients to take profits.
So the current system of fees encourages herding and bubbles. It contributed to the Nasdaq bubble of 2000 and the credit bubble that followed. As asset managers take ever more power from banks, the problem will only intensify.
BUT how to shift to something better? Unilaterally charging for performance alone is risky. For a cautionary tale, look at Vinculum.
This was an interesting startup launched by Nigel Legge, a prominent London investor with several successful ventures behind him. It had a simple concentrated investment strategy with low turnover — exactly the kind of behaviour that should be encouraged in active managers.
Vinculum also aggressively announced it would not take any fees unless it beat its index — in which case it would take half of any profits above the benchmark. Herding was useless.
But Vinculum died a swift death, failing to raise enough funds to be viable. Its attack on others’ fees alienated intermediaries, and so-so performance starved it of funds to keep going.
This is a problem for any startup. If you charge only for success, you have to succeed early to keep yourself viable — which means that, at least initially, such a fee policy could encourage reckless short-termism.
How to deal with this? It helps to have a huge reputation when you launch. Neil Woodford, one of London’s most famous managers, launched a genuinely radical system for his new Woodford Patient Capital fund last year, promising not to charge anything above basic management fees until it has managed an absolute return of at least 10%.
ANOTHER approach comes from George Cooper, best known as the writer of The Origin of Financial Crises, who plans to launch a manager called Equitile this year.
For each fund it will levy a management fee of 0.7% on the first £350m of assets it manages, and a 10% fee (generated only by beating the benchmark) on assets above this amount. All shares would be charged the same weighted average of the management and performance fees — so the importance of performance grows as the fund gets larger. The bigger it gets, the greater the imperative on the manager to beat the market.
Could this work? The experience of Orbis Asset Management suggests it might. It has about $40bn in assets and has been around since 1989, so its model is viable. Again it only charges for performance, which is judged against a benchmark. It makes this model work using a “reserve”, which receives money when the fund is underperforming, and pays out to managers when it is performing well.
The greatest issue in all cases will be complexity. In Orbis’s case, its fees explanation runs to 14 pages in the fund prospectus. But this should be surmountable. Fund managers charging such fees are offering a better deal for clients, which could help markets function far better. We should all hope they succeed. © Financial Times Limited 2015
Vinculum also aggressively announced it would not take any fees unless it beat its index. Herding was useless