There has been so much to think about recently that I have been a little distracted from the nuts and bolts of the financial services industry.
It’s hard to focus on the various scams and shenanigans of the UK’s money managers. There are too many other things to focus on: why Scotland has one of the few parliaments in the world without a second chamber; the UK electorate unexpectedly proving that it gets the point of capitalism; the multi-decade global bond bubble laying the groundwork for a bust; and the fact that some of the stock markets I like are suddenly doing exactly what I suspected they would (I’m thinking of the boom in Chinese shares).
It’s all rather thrilling.
But the good news is that behind all this macro drama, exciting things are happening in the world of fund management fees, too.
I have complained about the way in which we are charged by our fund managers here many, many times. I don’t like the way most of them charge fees based on the value of your assets. That’s partly because the fees are almost always too high (fund management is one of the greediest professions I know), but it is also because this traditional structure incentivises the wrong thing.
If you get paid more for every pound you bring in – regardless of performance – you focus on gathering assets and on hanging on to them by making your performance entirely unremarkable relative to some index or the other. That’s why the UK market is jammed full of mega funds that devote their efforts partly to collecting more money and partly to making sure the returns on that money track those of the index. It’s expensive and in the context of what investors want (to be rich) it is pretty useless.
But worse than this has been the industry’s response to the problem – to chuck in performance fees on top of their rapacious base fees. The idea here is that performance fees align the interests of fund managers with investors – when you make money, they get paid (more money).
This is, of course, nonsense: it only aligns half of their interest with ours. When we lose money, they don’t lose money. They don’t even hand back previous performance fees. This just adds an extra rubbish incentive on top of the previous rubbish incentives – it encourages them to take whopping risks after periods of underperformance in order to trigger the performance bonuses they need to pay their kids’ school fees and their outsized mortgages.
The rise of the hedge funds has made some difference to the conversation on performance fees. While they make the mistake of regularly overcharging, they have at least made ‘high water marks’ (which attempt to ensure that investors don’t pay high performance fees for poor performance) and proper targets the norm. Overall however, there has been remarkably little movement or innovation in this area for years. It is just maddening.
But that might be changing. I had breakfast recently with the charming Professor Tim Congdon. I complained about this to him (you can’t talk about monetary policy all the time). He asked why I bother even thinking about it. “Just leave it to the market,” he said.
My first response was to say that the oligopoly of distribution in the fund world means that the market isn’t working here. But then I started to think of some of the meetings I have had recently and I see that it is. It is slow, but it is happening.
The most obvious move in this area is from Neil Woodford with his new Patient Capital Trust. It charges an admin fee to cover its ongoing costs, and then a performance fee on the growth in the net asset value (rather than the share price) of the fund. The performance fee is nicely structured. It’s long term, it has a high water mark built in, it is high but not super greedy (although I do wish it was capped) and it is to be mainly paid in shares, not cash.
That said, the ongoing charges – expected to be about 0.20% – still add up: on the £800m Woodford has raised, the annual revenues will still be £1.6m-ish in the first year. Woodford might not be drawing anything out until there is performance but the fund isn’t free either (I’m not suggesting it should be, just pointing out that on very large funds, low looking percentage charges still add up to real money).
A similar model is offered by Tellsons on their newish Endeavour Fund. You can choose to pay a regular management fee (giving you a ongoing charge of 1.31%) or to just pay an admin fee of 0.31% and then a well-structured performance fee. For the managers to get paid, the fund has to make money in absolute terms rather than just relative to an index.
Another interesting model comes from Orbis Access. It again focuses entirely on performance, with the fee being 50% of anything over their benchmark. It comes with some of the usual problems – 50% is far too much, for starters, although the manager’s take is at least capped at 2.5% of the fund; it is almost impossibly complicated; and the fee (or lack of) is calculated daily, which I suspect will end up incentivising some of the wrong things.
On the plus side, the system incorporates something I haven’t seen before – refunds. The managers put their performance fees into a reserve and on the days they underperform, they pay 50% of the under performance back into the fund. That’s a very nice touch.
So what’s the best model I have seen so far?
Right now, it may come from Andrew McNally and George Cooper, the founders of a new fund management firm called Equitile. There’s nothing here for you to invest in yet (when there is, I am certain that the firm’s focus on corporate resilience will make it worth investing in, and I will tell you all about it).
When McNally and I met recently we talked about a system whereby a low percentage fee would be charged on enough of the assets under management to cover the costs and basic pay of the business (remember, you have to pay good managers just enough to stop them leaving to work for more aggressively rapacious businesses) and a performance fee on the rest.
So perhaps you would charge 0.4% on the first £400m under management (giving you revenues of £1.6m) and then a low and properly aligned (ie very long term) performance fee on any money you raise after that. After all, while it might cost £1.6m to run £400m it doesn’t follow that it costs £3.2m to run a £800m fund.
So this system takes away the fact that even a low management fee turns into a super profit generator at a certain point of asset gathering, and it rewards keeping the fund at the kind of size where regular outperformance is actually possible (go too big and it usually isn’t). It still isn’t perfect of course – I still hanker after a flat-fee fund management business (one with a set absolute price for the fund as a whole).
But the key point is that capitalism is doing its work here – interesting, innovative and clever people are entering a stale market and trying to attract customers by offering better-aligned products. Given that, over the long term, the price we pay to invest is still the major determinant of our returns, that’s a very good thing.
• A version of this article was first published in the Financial Times.