It is rare for investment managers to write about investment management fees. Like the artist who struggles to describe his ceramic pot in monetary terms, high quality investment managers prefer to build portfolios that deliver client objectives while leaving fees to their business colleagues.
Investment management services are typically charged for by one of two methods. The most common is to charge a fixed percentage of assets managed for example, 0.75% per annum. This fee is set at a level which covers the costs of the investment manager and which also delivering a profit to the owners of the business. Critics point out that the manager earns his fee, and presumably a profit, regardless of the success of the strategy. To determine this, one needs to be clear on the investment objective. All investment managers should be able to express what their investment objective is. Under a flat fee scale the value of the fee shrinks when portfolio values fall and rises on growth. If increasing the value of an investment portfolio is the objective, this way of charging seems to align interests quite well.
The second way of charging is to explicitly tie the fee earned to the performance of the portfolio. This is referred to as a performance fee. This method of charging was devised by Phoenician sailors who took a fifth of the value of a cargo as payment for a successful voyage. It was first applied in financial services by Alfred Winslow Jones in 1949 who is acknowledged as the “father of the hedge fund industry”. Jones’ used the term “performance reallocation” to describe the means by which he took twenty percent of the value of any profit made in place of a fee. Critically, he charged no management fee and therefore there were no revenues to cover his fixed costs in years when he lost money. Somewhat disappointingly perhaps, the real driver behind the fee structure was a reduced level of taxation for Mr Jones.
The more modern take on the performance fee approach is to charge both a flat fee on assets, ostensibly to cover the costs of doing business, and then to apply a performance fee as an incentive to encourage the investment manager to attempt to maximise performance. That at least is the general justification given. If true, firms adopting a performance fee structure appear to have exceptionally large operating costs – typical charging structures are 1 and sometimes 2 percent flat fee combined with a 20% performance reallocation. In an inflationary world, a performance fee structure is loaded in favour of the investment manager. Where this structure is perhaps reasonable, is if the performance fee is earned only when the investment manager achieves an objective, for example attaining a return that is 2% ahead of an index. Over the long term, beating a broad index by 2% per annum is only achieved by small number of investment managers.
The debate over the best approach to fees will rumble on. We observe that performance fee structures are inherently complicated in practice and we grow increasingly sceptical when an investment discussion is hijacked by a fee discussion. As a rule, we prefer the Keep It Simple Stupid principal.
Most recently there has been discussion of a hybrid fee structure, which one group has called a “fulcrum fee”. This structure offers a flat fee that varies according to the extent to which a predetermined objective has been exceeded or fallen short of. This is a performance fee structure in all but name and will involve all the complexity of calculation inherent with these structures.
We observe that great investors are rarely the most expensive, but it is also true that the best outcomes are unlikely to be achieved via the lowest cost route – a certain Mr Madoff charged no annual investment management fee and that formed part of his dastardly lure.