Why paying clients to manage their money is no longer such a fanciful idea

Talking to The Boston Globe three years after Vanguard rolled out the first index mutual fund in 1976, Fidelity’s then chief executive Ned Johnson said: “I can’t believe that the great mass of investors are going to be satisfied with the ultimate goal of just achieving average returns . . . I can’t conceive of investment managers not even trying to do better than average.”

Fidelity’s recent launches of zero-fee index funds in the US shows how times have changed.

It has taken an active manager to take the plunge with an expense ratio of zero and no minimum investment requirement.

Although it is confined to four cap-weighted funds, the genie is finally out of the bottle in the price war between mega indexers. Competitors will be watching the fund inflows with hawkish eyes. 

Active fund managers will be just as vigilant. With a large majority of them unable to beat their benchmarks this decade, they have suffered the double whammy of fee compression and fund outflows. Unsurprisingly, after Fidelity's first announcement, the stock prices of active managers — such as Franklin Resources, Invesco, Legg Mason and T Rowe Price — tumbled.

This underscores a new fact of life: fees have become the north star of the global asset industry as quantitative easing has borrowed against future returns. Data from JPMorgan, for example, show that nearly 75 per cent of the net exchange traded fund inflows in the US in 2017 went to funds with the lowest expense ratios. The winds of change are evident.  

The Pennsylvania Public School Employees’ Retirement System recently passed a resolution to reduce the fees it pays to its external managers by $2.5bn over the next 30 years — by renegotiating fees with existing managers and expanding its internal investment capability.

In Australia, the former revenue and financial services minister Kelly O’Dwyer warned that unwanted fees and insurance premiums on multiple superannuation accounts are a “massive rip-off”. She welcomed a proposal to create a body to recommend 10 high-performing funds (net of fees) to employees, raising the spectre of a mass shake-out in the Aussie asset industry.  

In Japan, the $1.4tn Government Pension Investment Fund is implementing a two-part fee structure for active funds: a minimum base fee and a performance fee linked to the excess returns they generate. Failure to deliver them means managers only receive a base fee equal to that of passive funds of similar size.

The needle is shifting. Worldwide, fee compression is the norm, marking a revolution by evolutionary means. It is most evident in new mandates, while legacy assets remain locked into the age-old “heads I win, tails you lose” fixed percentage fee linked to assets under management. While encouraging asset gathering, this asymmetric structure rewards asset managers irrespective of outcomes. It also generates windfall gains in rising markets as the icing on the cake. 

Variants of the GPIF approach are now emerging where asset managers are cutting their ongoing fees in return for a share in the profits generated by their funds.

Typically, the low base fee comes with a share varying between 5 per cent and 10 per cent. Some mandates have zero base fees but receive anywhere between 5 per cent and 25 per cent of profits. Thus, fees rise when the fund outperforms and falls when it underperforms. In all such mandates, fees accrue over a longer period to ride out the vagaries of the financial markets. Some mandates also have the base fee expressed in fixed monetary terms to eliminate the asymmetric pay off.

Thus, via modest steps rather than giant leaps, fee models are undergoing a makeover that ensures a better alignment of interest and longer time horizons. They aim to encourage asset owners to stay invested longer, while requiring active managers to eat their own cooking. Above all, they aim to fend off competition from low-cost index-tracking funds.

So earnest is the search for new approaches that Mercer, the pension consultancy, has recently proposed what sounds like heresy with a Darwinian edge. Far from charging a fee to their clients, it argues, active managers should actually pay their clients for the privilege of managing their money. Managers should retain any additional gains they make after delivering a guaranteed return plus a fixed annual fee.

The aim is to discourage asset gathering that dilutes returns once capacity ceilings are breached and to flush out the mediocrity that has long survived under the clock of simple fixed percentage fee. 

The Mercer idea is no more fanciful than Fidelity’s zero-fee passive funds, disparaged in the past by the industry’s senior executives when first mooted on the conference circuit. History shows that, in asset management, the heresy of today can be the orthodoxy of tomorrow.

Amin Rajan is CEO of Create-Research and a member of The 300 Club