bFinance: Fees Down But Investor Costs Up

May, 2017

Although investors’ costs have never been more vigilantly scrutinised than they are today, the average large pension fund is paying out a higher proportion of their AuM in investment costs than they were ten years ago due to more illiquid investments, new premium strategies promising higher yield and unexpected pricing resilience in certain asset classes. Yet investors can exploit recent fee reductions in specific strategies and sectors to improve value for money. These are the key findings of the latest report from bfinance “Investment Management Fees: New Savings, New Challenges”.The report reviews the three fee-pressuring trends that have been bearing down on fund managers, with a climate of mistrust following the global financial crisis, greater understanding of various betas dressed as alpha and a low-rate climate that has made every basis point worth fighting for. Although net performance is the most important metric, a new mindset holds sway, since future performance is uncertain while cost reductions represent certain gains to be compounded over time. Many investors have sought savings through switching investment strategies, bringing functions in-house or dragging vendors back to the negotiating table.Certain asset classes and sectors have faced far more pressure than others and the report shows how asset managers have responded, lowering costs in some areas while pushing newer, more expensive products in others.Active global equity fees are surprisingly resilient, falling just 8% since 2010-2014 despite intense pressure from passive and smart beta products.The reports finds that active global equity management fees have fallen by a meaningful amount, but the fee reductions in other sectors such as smart beta (down 25% since 2011) and low volatility (down 24% since 2010) have been far greater. The authors suggest a number of causes for this resilience, such as the transparency relative to other sectors (causing a tendency to cluster around known average fees) and the trend to position active offerings as complementary to systematic strategies rather than competitive. Managers have focused on metrics such as idiosyncratic risk exposure and active share, to distinguish themselves from smart beta and passive funds respectively. Also in equity, investors shift from performance fees towards management fees and explore new structures such as flat rates.Fund of hedge funds cut fees dramaticallyFund of hedge funds (FoHF) have sought to regain lost ground since the post global financial crisis (GFC) rout and this report reveals that average management fees have fallen by 20% globally and nearly 30% in Europe since the 2010-2014 period. The challenge to attract asset inflows into FoFHs has been made more complicated by the evolution of alternative beta and the growing popularity of various multi asset or diversified growth strategies.Private markets present a difficult picture, with managers often holding the upper handPrivate market manager fees have remained high, particularly in infrastructure and private equity, and have even worsened in some cases, with too much money chasing the available supply of opportunity. “Why have certain very popular private equity managers done away with hurdle rates? The answer is very simple: because they could,” says Anne Feuillen, a Senior Director in bfinance’s Private Markets division in the report. “But this has a meaningful negative impact on net returns and reduces the alignment of interests between GP and LP. It is very hard for investors in this fundraising climate to say: “no, that is a step too far.”However, there are certain areas within private markets where fees have come down a great deal. The report highlights private debt strategies where base fees have fallen by more than 30% since 2014. Private equity fund of funds, particularly those focused on primaries, have also become significantly less expensive. Investors in these sectors should ensure they capture these savings.Despite falling fee levels across a number of asset classes total fund costs are risingDespite these falling fee levels, data from CEM Benchmarking shows that total fund costs of the institutions in their database have risen from 37.8 bps to 57.3 bps over the past ten years. A significant factor in this trend is the growing demand for illiquid investments and alternatives.Another factor is the launch of more expensive funds in public markets: unconstrained, absolute return, asset allocation or advisory products have proven increasingly popular. One example analysed in this paper is Unconstrained Fixed Income, which is priced at a premium to conventional Global Aggregate funds. This relatively immature sector is “a pricing shambles,” the report says, with fees highly dispersed around a 48bps median and, surprisingly, little correlation between the prices and the nature of the strategies such as the amount of risk or the proportion of different types of fixed income. bfinance expects such fees to come down.New consultants and services have emerged to help investors reduce fees.A plethora of new providers have emerged to service the cost reduction mission, encouraging a deeper understanding of underlying processes such as transaction fees rather than relying purely on benchmarking and price comparison.BT Pension Scheme case study shows how seeking value for money can pay off.This paper includes comments and contributions from numerous investors around the world, including Canada, Australia and Europe. One case study from BT Pension Fund in the UK shows how this investor reduced its fees by 25% without sacrificing diversification or giving up its commitment to active management. Better benchmarking and monitoring, fewer and larger mandates, strong fee negotiation with a pressure on excessively generous “alpha share”, a movement away from performance fees and the introduction of fee caps have all helped to achieve this outstanding result.Key takeaways for institutions from the reportbfinance offers three takeaways: “renegotiate, reassess and reprioritise.” Where significant price reductions have taken place, now may be the time to bring providers back to the negotiating table and get fees in line with new practices. If fees proved to be a crucial factor in investment strategy, such as the choice of single hedge funds versus FoHFs, it may be worth examining the question again. Finally comes the question of priorities: stakeholders should always remember that, while asset allocation is always preeminent, implementation risk is increasingly critical to investor outcomes for today’s more illiquid and expensive portfolios. Asset allocation strategy and implementation reality are not always aligned and bfinance advises that the conflicts between the two should be recognised and governed rather than ignored.Kathryn Saklatvala, global content director at bfinance and the report’s author said: “We are pleased to be able to share this data, showing fee reductions in particular sectors including global equity, fund of hedge funds and private debt, as well as giving some insight on less well understood areas such as unconstrained fixed income.“There are fascinating trends going on, particularly in global equity where active management fees have been surprisingly resilient in the face of intense competition from smart beta and passive funds. Yet there’s a clear bifurcation, with cost reductions in products with strong factor exposures, such as low volatility active management.”David Vafai, CEO at bfinance, says: “We hope that publishing information on fees quoted by asset managers, as well as negotiated discounts, will help to promote the interests of asset owners. But it is important to remember that visibility can be a double-edged sword: while benchmarking can help to ensure that investors don’t over-pay, it may also make managers less likely to offer prices significantly below the average. We at bfinance are continually seeking ways of addressing this challenge.”“It is also important to remember that fees and costs, although they are the focus of this study, are never the most important metrics. Although we point to sectors where significant fee reductions have taken place, and encourage investors to take advantage of them, we certainly do not seek to advocate cost reduction for its own sake. Value for money is the most important priority and we appreciate that more robust and diversified portfolios may deliver higher net performance despite greater expense.