By Nick Curtin, Foord Asset Management
Investment management fees in general and performance fee structures in particular have attracted a lot of attention in recent times. This is unsurprising given the National Treasury’s myriad reform proposals across the savings industry and a lower return market environment. The debate should be welcomed by all who have an interest in ensuring good value for money in South Africa’s long-term savings industry. It is first important to clarify what “good value for money” actually means.
The concept of cost versus value is important to the definition of good value for money – “cheap” does not necessarily equate to “good value”. When drawing conclusions therefore, the focus should always be on return outcomes after costs (for both active and passive alternatives). If cost is 1% but the investor receives a 15% return, the after cost value for money is better than if the cost is 0.50% and the return is 10% (all else being equal).
In short, it is possible to pay a premium price and receive a premium outcome. Likewise it is possible that paying peanuts begets mediocrity. As the saying goes, cost is what you pay, value is what you get and cost should only become the major issue when value is in question. The assessment of “value for money” must be calibrated as such.
Importantly, fixed fees do not necessarily equate to lower fees. Compared to performance fee structures, fixed fee methodologies simply move a large chunk of the fee from a variable charging structure that is contingent on actual delivery of outperformance to a fixed structure that is charged regardless of actual delivered outcomes. This could equally result in higher cost outcomes on average as it could result in lower; there are many variables at play. To assume one outcome over the other would be disingenuous.
Accordingly, many active managers are typically agnostic between performance fee and fixed fee charging methodologies. Generally, as a private sector business, an investment manager’s investment capacity pricing is achieved through careful analysis of: value proposition; competitive advantages; market competition; business growth strategy amongst other metrics. As with any private enterprise subject to market forces, these entities will survive and thrive, or not, depending on how they deliver on their value proposition to their customers. Lastly, it is important to dispel the myth that a performance fee is a fixed fee with an additional sharing rate component. In fact, it works in the opposite direction – it is the fixed price for the service disaggregated into a fixed component and a component that is contingent on performance. If investment manager X has determined that the price for the firm’s investment capacity is Y, then investors can either pay Y (fixed) or they can pay (Y-Z) fixed and only pay (Z) on actual delivery of the anticipated outperformance.
Performance fees introduce optionality into the cost structure that is only actually paid by investors if the actual delivered outcome (i.e. value received) is in excess of the passive alternative (or another agreed benchmark). This pricing optionality is clearly in the members’ best interests and only in the managers’ best interests if they actually deliver their expectation. In our view, if correctly and ethically implemented, performance fees epitomize the alignment of interests between managers and investors.