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Fees Under the Microscope: Successfully Navigate Management and Performance Fees

On-demand webinar from Broadridge.

The asset management industry’s traditional fee model and pricing structure continue to face enormous pressure from investors, market regulators and less expensive passive investment funds. Consequentially, fees are becoming less standardized and increasingly complex. An intelligent and thoughtful approach to performance fees and management fees is required to successfully navigate these challenges.

This webinar features:

Robert Kelly discussed informed pricing strategy analytics: He reviewed data from Broadridge’s Global Market Intelligence (GMI) Fees module – a consortium of more than 50 asset managers providing net negotiated investment management fees for their institutional clients across pooled funds and separately managed accounts. The module now tracks 70,000 agreements from global institutions across the full spectrum of asset classes.

“The Broadridge GMI fees module is a tool kit that helps asset managers inform their pricing strategy and tells them how best tactically to respond to RFPs.”
- Robert Kelly

Video Transcript

So now I'd like to introduce today's first presenter, Rob Kelly, Director on the Global Market Intelligence team for Broadridge.

Thanks, Randy. Over the next few slides, we're going to look at a couple of key topics. First, we're going to look at the current environment for investment management fees for institutional clients and the degree of fee compression taking place. Second, we're going to look at the prevalent performance fees and in particular in which client groups the greatest demand is coming. The data for this section of today's webinar comes from the GMI fees module.

The GMI fees module is a tool kit that helps asset managers inform their pricing strategy and tells them how best tactically to respond to RFPs. Data comes from a consortium of 55 asset managers by Broadridge with a net negotiated investment management fees and details on that performance fees on a quarterly basis across 70,000 institutional agreements.

Let's turn to our first topic, the state of institutional investment management fees today and the degree of fee compression taking place in the market. The turmoil of the last two years has not led to any respite or deviation in previous downward pressure on fees that we see, thanks to the continued competition for new business between asset managers and also renegotiations to keep hold of existing clients. But while pressure on fees is taking place across the board, the impact is not uniform between asset classes.

Managers need to stay informed, otherwise risk pricing uncompetitive certain products. The chart that you see now put some solid numbers behind those trends we picked as a few asset classes to highlight the change in weighted average fee over the past year. The two bars represent the absolute changing in fee, while the purple diamond represents the percentage impact.

If we look at equity fees on the left first, we can see the active fundamental fees have fallen by roughly one percent. While passive fees have fallen by about three percent.

Have a look at the impact on all equity you can see with the the full is about five percent over a single year. And this comes down to the impact of the compression effect on the fees, but also the composite composition of effect. Clients are moving from active to passive management of equities, meaning that there's an additional impact on those equity fees overall and therefore also revenues. Meanwhile, among fixed income, we can see that the downward pressure on these over for the one-year period was roughly one percent. However, it felt fittingly fast among EMB passive fixed income and also flexible bonds.

Again, the composition affect means that institutions have been moving in search for you, higher priced products, meaning that across the board for fixed income, we only saw a one percent fall, even though some products were hit particularly hard. What is clear is that asset managers will have to get used to this low fee environment. An environment that is also fast changing and one that manages need to stay informed about and on top of trends.

One of these trends is the increasing prevalence of performance fees. And that's what we're going to look at on the next slide.

Let's turn to a second topic in this election, the prevalence of performance fees and from which client groups the greatest demand for them is coming. More institutions are looking to align their outcomes with the value delivered to them by the manager and the use of performance fees can be one element in that.

Looking here on this slide at institutional separate accounts, we see the performance fees still only used in a small minority of cases, but they are more common for certain products and certain strategies. We see on the chart on the left that they are more prevalent for equity mandates where they are used in six percent of those agreements that we track.

This compares to much lower figures for multi-asset or fixed income of three percent and two percent, respectively. On the right hand side, we break out these strategies, which have an even higher use of performance fees. Within equities we see the highest proportion comes from within the Vatican sector equities plus global and global emerging strategies.

Performance fees are much less frequent for fixed income mandates, but again, on the right hand side, we see that certain strategies feature performance fees more heavily, notably global corporates, structured finance, EMV and global flexible bonds. What is special about these strategies on the right? In general, they tend to be associated with a greater scope and choice of investment and also potentially a greater risk involved. There's more upside and downside potential to the investments.

Some clients want to use performance fees to make sure their outcomes are more closely aligned with the service and investment return that managers deliver to reduce that downside potential, but which clients specifically? That's what we're going to turn to on the next slide.

Using the GMI fees module, we can slice the data by client channel and to manage performance fees. So far, what we see is the performance fees have been most taken up by certain US client channels and by sovereign wealth funds globally. In order to control for asset class differences on this flight, we look at active equity separate accounts.

The chart on the left shows that across all channels, we see the figure from the previous slide. Six percent of equity separate accounts use performance fees.

We then break that tape by client channel, we see that the client groups with the highest shares of performance fees are sub advise business or business from other asset managers.

Sovereign wealth funds, not for profit institutions such as trust foundations and DB pension funds. We've seen very little evidence so far of performance fees being used by DC pension funds, family offices or private banks, by insurers or by corporate or bank treasuries. On the right-hand side, we can break this out by global region as well.

And if we take a look at the top six channels that we've broken out, we can see that four of them in blue are US based channels. Plus, APAC and EMEA sovereign wealth funds. So why these channels, in particular, using performance fees, they tend to be more sophisticated investors with larger average mandate sizes. In general, they tend to be more likely to go into riskier equity fixed income strategies that we saw earlier are more likely to involve performance fees, and they are also more likely to value long term benchmark outperformance. They also cut the scale bargaining power necessary to tell asset managers that they want to align their outcomes with the value that managers have promised to be little.

Going forward, this is very possible that we see these trends change, perhaps with an increasing use of performance fees in EMEA and APAC in some of those client channels will be focused on here. So, for managers is very important to stay on top of any developments and trends in this space.

Steve Richardson reviewed performance fees and management fee billing: Broadridge supports asset managers in streamlining their performance and management fee billing and invoicing operations. Learn why 180 asset managers globally – including 15 of the top 20 – use our revenue and expense solution to improve the quality and accuracy of your fee invoicing processes, including FX/multi-currency, Tax/Vat Tax, Rebates/Retrocessions, performance fees, and management fees.

“As more funds move from a flat management rate to a variable performance-based fee model, this will increase pressure on the fund, administration, and finance teams to accurately calculate these more complex fees. And this is exactly where a comprehensive revenue and expense management solution can help.”
- Steve Richardson

Video Transcript

 Next speaker is Steve Richardson, Director on the Revenue and Expense Management Solution team for Broadridge.

Thank you, Randy, and welcome everyone to our second topic in today's webinar. As Randy said, I work with the Revenue and Expense Management Solution at Broadridge, where we specialize in invoicing, fee reconciliations and expense calculations in the investment management world. Following on from Rob's excellent overview of management and performance fee trends in the market, I'm going to dive a little deeper into the performance fees themselves, whether they achieve their objectives, how they're calculated, and where Broadridge's Revenue and Expense Management solution can help.

The fund market today is facing a downward pressure on fees of mutual funds driven by the popularity and huge inflows of capital into the competing passive funds. Attracting capital to new funds is always difficult and there have been even cases where startup funds have been created with a negative fee in order to attract new capital. Overall, this has put pressure on the actively managed funds to also reduce their fees or alternatively replace them with more inventive fee structures. As we know today, mutual funds charge different types of fees for their investment management services.

The most common of which is a fixed percentage on assets under management. For segregated mandates, we mostly seated management fee structures where rates are defined in bands which are ultimately designed to provide a discounted effective rate as the investors assets grow. In addition to this, a growing number of funds earn incentive fees if they can outperform a relevant benchmark. In the hedge fund market, this has been commonplace for years with the two and 20 model, where a flat 2% management fees charged to the base fee, which with an additional 20% fee charged on performance.

This type of incentive fee is called an asymmetric performance fee, where the fund manager is rewarded for outperformance relative to a relevant benchmark over an agreed assessment period. Asymmetric performance fees are common in hedge funds and also in the segregated accounts with our usually combined with a discounted management fee rate. These isometric performance fees are controversial. Firstly, they do not penalize the manager for poor performance, having no claw backs. Secondly, where a performance-based incentive should in principle align the fund manager with the investor.

Given that both parties benefit when the fund performs well, it could be argued that these asymmetric performance fees can lead to excessive risk taking, or indeed the opposite could be said when funds are performing well. It could also be argued that the fund manager could de-risk the portfolio to lock in their accrued performance fee. Because of this, in 1971, on the recommendation of the S.E.C., US Congress prohibited the use of asymmetric performance fees on US mutual funds.

In Europe, things are a little different where performance fees are allowed under UCITS. But national regulators have their own restrictions in place. But there is another type of performance fee designed to protect the investor, which imposes a penalty for underperformance equal to the charge for outperformance. This is called the symmetric performance fee or sometimes called the fulcrum performance fee. When a fund outperforms its benchmark, it can charge a higher rate, and when it underperforms, it charges a lower rate relative to the original funds management fee.

As fee models continue to evolve, we're starting to see more funds appear which utilize this model as they are allowed on mutual funds. As more funds move from a flat management rate to a variable performance-based fee model, this will increase pressure on the fund, administration, and finance teams to accurately calculate these more complex fees.

And this is exactly where a comprehensive revenue and expense management solution can help. On the next slides, we're going to look a bit into the asymmetric performance fees and how they're calculated. Followed by a look symmetric performance fee, followed up by a general view on any sort of remaining performance fees that the market sees.

So looking first at the asymmetric performance fee, I thought it'd be a good idea to present this on a simple chart. On the x axis we have our fund performance ranging from fund underperformance to fund outperformance. And on the Y axis we have an annual management charge. Starting first with the management fee rate, this will be the fixed fee that is charged on the fund regardless of any performance considerations.

And the benchmark in the middle is where the fund is meeting the benchmark. To the right of that, we have our fund outperformance, but in most cases the fund managers won't charge any performance fee until a specific level of outperformance has been achieved.

And this is known as the hurdle rate. And to the right of the hurdle rate on this chart represented by the pale green box. This would be known as the access return. Once we take our access return, we then apply our participation rate or performance fee rate.

And this would be the amount of fee that is charged on that excess return. And in most cases, this would be a completely uncapped fee, and we'll continue just to keep charging a percentage of that excess return.

And however, some managers may put an additional cap, which is an option and fairly rare in the marketplace. The issue of contention of this performance fee is that when the fund is underperforming, i.e., when it's on the left-hand side of this chart, there is no reduction in performance fee. And the investor will still be having to pay the flat management fee rate.

After looking at the structure of an asymmetric performance fee, how can we turn this into a system approach for fee calculation? Well, lucky for us, we do have a standard function within side the system which allows us to calculate asymmetric performance fees. And what we need for this is to provide some variables for the system to calculate.

So first of all, we need our account return or return this really that could be the fund return or portfolio return. And these will typically be an annualized figure that is provided to us from a performance attribution system. Next, we will need our benchmark return to which to calculate or compare against.

And the cool thing with a benchmark return is these are reusable across different performance fees. So, you could have multiple performance fees in the system calculating against a standard set of benchmarks. Next, we will need to provide the or specify the hurdle rate for this particular performance fee agreement, followed by the base rate, followed by the measurement period on which we want to calculate. So typically, this could be an annual period, but we allow for monthly, quarterly. And there may be some cases where you have three- or five-year periods on the issue on which you wish to calculate.

Finally, we'll need to provide some valuations on which to calculate, and these will be provided to us from portfolio management systems or alternatively, custodians. So, if we take these inputs, we can have a look at an example. We have the right-hand side, and we can see that we have a quarterly invoice, and the average assets are based on the last four-month end average. Once we have the average assets to charge on, we can then start to pull in our performance fee variables. In this example, we have our account return at 10.5% with our index return or benchmark return at 5.6%, a hurdle rate 0.4%.

And finally, a base rate, 0.9%. And to calculate the excess return, we simply need to deduct the index return, hurdle rate and base rate from the account return. And that gives us 3.6% of excess return. Now, these fees, as we said before, will only calculate once the excess trend is above zero.

So, it's undesirable, no invoice or calculation will generate. But in this case, we have about 3.6% on which we need to calculate our performance fee. So, we take our excess return and we multiply it by the participation rate or the performance fee rate, which then gives us our performance fee for the period.

And the cool thing here is that this will calculate on any period that we wish, as long as we're feeding in our valuations and our account return and our benchmark return. This can be generated on any cycle. Just a simple click of a button. So, from here we will change up now and we'll start to take a look at the symmetric performance fee on the next slide.

Again, I thought it'd be a good idea to show the symmetric performance fee on a simple chart as before. So again, on the x axis we have our fund performance ranging from fund underperformance to fund outperformance. And on the Y axis, we have our annual management charge.

In the middle, we have our benchmark, which is the point at which the fund return equals the benchmark return. And in this case, we could also call this the fulcrum point of our calculation. Which essentially says our baseline management fee, i.e., when the fund is performing as per the benchmark target to the right of the benchmark line.

When the fund outperforms the benchmark, we apply a positive adjustment to the fee. When the fund underperforms the benchmark be to the left of the benchmark line, we apply a negative adjustment to the to the fee. Additionally, to this, we also have a cap and a floor to these fees. So, when we're out charging outperformance, we can only charge up to a specified amount and again on the floor we can only charge down to a specified amount.

The floor is essentially our new minimum rate, since this portion will always be charged and depending on reading and accounting treatments, this could be accrued with variable portion may not, not at least until it is crystallized. Therefore, we need to ensure from an accounting perspective, a fixed floor amount or minimum, and the variable portion above are kept separate. When these funds or specific share classes are created, they may be against an existing fund with a fixed management fee rate. Setting a slightly new reduce management fee rate, we're trying to attract new capital into this new fee structure.

We could see overall that this structure is more fair to investors because the amount of positive adjustment is equal to the amount of negative adjustment around that new baseline management fee. Hence the name symmetric performance fee. The real trick here for these particular agreements is to ensure that the benchmark is relative to the fund and ensuring that the amount of positive adjustment and negative adjustment really reflects how the fund is tracking against the market. 

Now that we've seen how the symmetric fulcrum model works, can we support these fees in an automated, systemized approach and employed manual work entirely? In Revport, we also support the symmetric model as a standard function. However, it works slightly differently to the asymmetric fee.

As we mentioned before, we essentially have a base fee or the floor and this needs to be calculated first. This is a fixed fee portion, which is in a way a heavily reduced management fee and forms the basis for our calculation. From this point, we add performance fee depending on how much excess return has been calculated as an adjustment amount.

Let's take a look at the inputs required and how this translates into an invoice format as shown on the right. Firstly, like the asymmetric performance fee, we will need an account return, a benchmark return, hurdle rate and the base rate. In this case, the base rate is used to calculate the floor rate. Next, we will need our measurement period for the calculation. And for this example, we will need a fulcrum fee schedule.

And this is where we specify the rates and ranges needed to calculate the fulcrum performance fee. So, this is where we specify the amounts we wish to adjust the performance fee by. In the example shown, there is also another slight twist. We actually need to have an excess return of 1.5% to reach the baseline management fee. The fulcrum point. This slows down to an excess of 0%, where no performance fee adjustment is calculated, essentially a 20% reduction in the baseline management fee.

On the positive adjustment side, where excess return is above 1.5%, the adjustment is capped at 3% or more of excess return, which equates to an increase of 20% in baseline management fee. As our fulcrum fee in this example or baseline management fee is calculating at 40 basis points, this essentially means our floor is at 30 basis points and our cap is at 48 basis points. And just to note, all of the value shown on the example of fully configurable and flexible, to see a variety of real-life scenarios. Finally, to feed into this calculation, we will also need our valuation.

So these are the same valuation data that we would need for the asymmetric model and indeed for any management fee calculations. It is possible for the symmetric performance fee adjustment and the base or yield floor to be calculated on different calendar periods. In the example opposite, the base is calculated on a monthly basis but rolled up into quarterly performance fee calculation.

Essentially equal be true up. Finally given we have an excess return of 0.5% here below our fulcrum of 1.5%. This calculates to a symmetric performance fee adjustment on this particular fee of £9,008. All of the inputs and calculation audit are available and easily presented onto an invoice, making it easy for clients receiving these fees to see how they're calculated, ultimately leading to less queries in the long run.

What about when performance fees are more bespoke or have logic existing outside of the standard functions provided by the system?

In Revport, where we need to calculate fees which aren't covered by the standard functions available, we have a wide variety of tools and accounts to create anything we want. Some of these variations are listed below. For example, one way to ensure performance fees are fairer to the investor is to only charge when the performance of the portfolio exceeds the previous high. This prevents charging a performance fee more than once, i.e. when the fund recovers after a market crash, it must recover to its previous high before being eligible for a performance fee.

This is where we need to track the high watermark. This concept also translates into more absolute terms when we consider carryforwards and claw backs. These are values to track running balances and need to be stored between periods and also may be considered as an adjustment when we calculate a future period performance fee. We might also need to support different performance fee models across the lifetime of a fund.

Report allows versioning of calculations, allowing us to specify different fee structures depending on which period is being calculated.

Typically, performance attribution systems handle cash flows when calculating portfolio or fund performance. However, there may be some cases where we need to consider the cash flows and their time waiting into the performance fee. Some other examples of annual performance fees may be invoiced over a period of three or five years. In the case of a three-year rolling performance fee in year one, only one third of the fee is invoiced. In year two, we would invoice one third of year one plus one third of year two, which continues for year three and onwards.

So, we need to be able to store and track these previously calculated fees over a period of years and ensure they're invoiced in the correct periods. Samples where an annual performance fee uses the average of monthly balances from the previous three years or through 36 months as the basis for the calculation. So we need to have the flexibility in specifying how far back to look. Finally, we have cases where performance fees are based on the price rather than the valuations.

All of these examples are handled by Revport, plus many more. We achieve this using a combination of custom logic, which is defined by the user in the system, much in the same way formulas are constructed in Excel as well as a flexible calculation engine.

So in summary, we've briefly talked about some performance for history and the two main types of performance fees we see in the market today. While the asymmetric performance fee exists in some areas, it's the arguably fairer symmetric performance fee, which might provide the fleet fee flexibility needed in a competitive marketplace.

Our clients today use Revport as a flexible fee calculation engine to calculate a wide variety of investment management fees, ranging from the simple fixed rate management fees to the more complex asymmetric and symmetric performance fees we have discussed. Utilizing the embedded workflow, we aim to produce invoices and statements with minimal human interaction and avoid time consuming manual processes and the errors associated with them.

At Broadridge, we also have an extensive outsourcing function where we can provide operational support for all aspects of the fee billing process, ultimately freeing up the finance and billing teams time to focus on other areas of the business. Finally, from a technical perspective, we have partnered with Amazon Web Services for AWS to provide a fantastic modern platform to host the report solution making use of all the latest advanced advancements in availability, security and scalability.

That's the end of my session on performance fees. Hopefully it was useful, informative. Any questions? And obviously please do get in touch.

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