The Hidden Challenges of Performance Based Fee Models

To a certain degree, the growth in index funds reflects investors’ growing awareness of the negative impact of fees on long-term investment returns and their resulting desire for value and clarity around what they are paying for. In today’s Post-MiFID II and PRIIPs world, this desire is mirrored across distribution channels. Regulators, shareholders and end-investors alike are calling for change, and increasingly asset managers are taking a step away from the well-worn paths of tradition.

Change is in motion. Following the UK Financial Conduct Authority’s (FCA) landmark 2017 review of the £7tn UK asset management industry, new measures introduced by the UK regulator and due to be in place by September 2019, aim to ensure asset managers act in the best interest of investors. In April 2018, the U.S. Securities and Exchange Commission proposed Regulation Best Interest, where a broker-dealer is required to act in the best interest of a customer when making a recommendation, and may not put its financial interests ahead of the customer’s interests. Managers will need to ensure that they can provide open and transparent evidence of funds’ value-for-money.

Firms with complex fee structures need a highly sophisticated billing and expense management system to calculate variable fees, and report on them to clients and regulators. Firms can no longer rely on spreadsheets, models or formulas to calculate fees as systems allow for the scale and auditability that Excel and manual processes cannot bring

But there is more to this picture than MiFID II, PRIIPs and some FCA pronouncements. EMIR, AIFMD and the ongoing ESMA directives are also contributing to the pressure for fund managers to review their modus operandi, to bring costs down for the investor, to make those costs more transparent and, ultimately, to improve value for investors.

The industry has responded by aggressive cost management initiatives and outsourcing. It is clear though that it isn’t enough.

Challenging the Industry’s Pricing Principle

With the index-fund market, including ETFs, continuing to attract a large share of the investor pie, mainstream active managers are looking for ways to better align investor appetites for low-cost Beta with managers’ interests in providing higher value and premium fee products. According to a growing number of active fund managers, there is no better way to do this than by challenging the industry’s most fundamental pricing principle: the traditional flat-rate management fee.

The world’s largest pension fund, Japan’s Government Pension Investment Fund (JGPI), is one of the vanguards of this movement. JGPI is shifting from an AUM- to performance-based remuneration system for the external, active fund managers it employs.

Last October, Fidelity International, the £301bn AUM asset manager, unveiled a new ‘fulcrum fee’ on its retail funds that will charge less when investments underperform. Earlier this year, Fidelity then revealed it is also mulling over introducing ‘time-based’ loyalty discounts for clients who stay invested for longer.

Orbis Investments demonstrated a distinctive approach. It charges no management fees, but half of its funds’ benchmark-plus gains are paid into a reserve, from which it takes its fee. When the funds underperform the index, the reserve pays a refund to investors.

Last year, Baillie Gifford cut management fees on 20 of its active funds. And in March this year, JPMorgan Asset Management announced it was cutting the charges on its UK funds and switching from a fixed expense model to a variable one.

The US asset manager said this would mean that fees fall proportionately as the fund’s assets rise, meaning investors can benefit from its economies of scale.

Other high-profile names that have introduced or announced funds with performance fees of various types, include both newer management houses such as Woodford Investment Management and long-established global brands such as Alliance Bernstein and Allianz Global Investors.

The Impact of Regulatory Changes for the Fund Management Industry

So, what do some of these changes mean for fund managers, their processes, systems and technology infrastructure?

PRIIPs and MiFID II have introduced significant methodologies on price transparency. Asset managers can no longer provide just an ongoing costs figure. Instead, they must now publish the Total Cost of Ownership (TCO) of their funds, including transaction or trading costs and other charges. Firms must now be able to accurately calculate, break-down, analyze and publish the details of their trading costs, fees and charges, at any given time.

MiFID II’s mandate for defined payments for research has also introduced an additional fee complexity for fund managers. Some firms chose to use the system of research payment accounts, approved by European regulators, to continue charging the cost of research to their funds. Many large firms, however, followed BlackRock’s lead and decided to absorb the costs against their own profits.

Looking forward to 2019, funds will be required to publish an annual statement setting out a description of the assessment of value. As value is not the same as cost, the assessment will be complex. Firms must consider the quality of service that investors receive, performance, costs, economies of scale and how the fund compares to others available in the market. Discussions continue around what an industry standard template should look like so that every manager can calculate and show costs on the exact same basis – but whatever it looks like, every fund manager must have the reporting, processes and audit trails in place to support these assessments.

The Need for a Flexible Infrastructure and Highly Configurable, Best-of-suite Solutions

One of the main findings of the FCA’s 2017 asset management market study was that institutional investors such as pension funds and insurers found it difficult to get the necessary cost information to make effective decisions. This is unsurprising as most asset management firms struggle to understand their own costs at a portfolio or fund level.

As product line-ups, fund structures, investor bases and geographies expand, and variations in fee schedules and structures continue to evolve, active fund managers must look beyond the shop window. They must consider which solutions they will need to ensure they have the flexibility to respond to these innovative structures and fee schedules. At a technology infrastructure level, a high degree of flexibility will be required to support these changing requirements and ensure regulatory compliance.

Many firms have built up complex and integrated technology environments that are difficult to adapt. Simply adding more software and people to cope with these changing conditions often exacerbates the problem – adding more cost, complexity and risk.

Some firms end up with multiple finance systems, trading platforms and data warehouses that they must reconcile at an ever-increasing cost. In this quest to become more nimble and cost-effective, Heads of Technology and Operations are looking to consolidate their technology infrastructure with highly configurable, best-of-suite solutions.

The good news is that with the right fund products, and the right systems and processes to support them, active management is proving that it is still competitive and can continue to be an essential destination for investor’s capital.

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