Incentives and alignment

'Asset gathering can be to clients’ benefit as a larger fund will generate increased income and profitability (as costs grow more slowly than revenues) and be more sustainable for an investment.'

While there are concerns about incentive structures and conflicts of interest in investment consulting, these are more acutely felt in relation to investment management. In essence, investment managers’ interests are closely aligned with those of their clients. If investment managers perform well (to their clients’ benefit), they will probably see the value of the investments that they manage increase and ay gather more assets and, operating under the ad valorem (AV) fee structure, they then earn more income. Equally, if the value of clients’ assets falls, then the investment manager’s income falls and the prospect for asset gathering worsens.

However, as the AV fee structure is linked directly to asset values it is thought to encourage asset gathering ahead of the appropriate management of existing assets. Asset gathering can be to clients’ benefit as a larger fund will generate increased income and profitability (as costs grow more slowly than revenues) and be more sustainable for an investment manager to support. However, asset gathering can also come at clients’ cost. Large funds may start to experience diseconomies of scale as they find it more difficult to invest without market impact. In addition, the profitability of a large fund (which might have an operating margin of 70% or more) may encourage the investment manager to reduce the fund’s risk in order to protect past performance and to avoid giving investors a strong reason to move their assets elsewhere.

Stakeholders also note that the AV structure does not distinguish between luck and skill. The investment manager’s income depends significantly on the movement of the market, rather than on the manager’s specific contribution alone. They also comment on the fact that, while AV fees might taper based on asset size for institutional clients, they are unlikely to do so in retail structures. Stakeholders regard the investment profession as being slow to share the benefits of economies of scale with its clients.

Alternative fee approaches exist (blends of AV and performance fees; zero base fees combined with high performance fees and symmetric approaches to performance fees so that under-performance requires past performance fees to be repaid), but are not widely used. Stakeholders comment that clients appear hesitant to invest in products that have different models, preferring the comfort of the standard AV approach even if it might not be well aligned with their own interests. In addition, they observe that the reductions in base AV rates offered in return for the application of performance fees (in theory a good way to align interests) is rarely sufficient to justify the move to such a structure.

Those that we spoke to for our report believe that the investment profession could do more to share the benefits of scale with clients (which might compensate them for the diseconomies of scale in relation to performance) and that new fee models should be considered based more directly on effort and skill. For instance, if an active fund has a relatively low active share, should fees be set so that passive pricing is applied on the part of the portfolio that follows the index and active fees applied only on the remainder?

It is notable that stakeholders broadly had few concerns about fee structures on passive products where fees are considered to reflect better investment managers’ inputs and where vigorous competition has pushed fees lower. Competition has also reduced fees on active products, but stakeholders do not perceive them as being as closely linked to inputs or the value they deliver

In our 2013 paper on fees and compensation, CFA UK noted that fee and compensation structures should be transparent and aligned with clients’ interests. Co-investment, in which managers and analysts invest their own capital alongside their clients, can provide a direct means to align the interests of clients and their managers. Stakeholders respect that approach, but observe that true alignment is only achieved if the client and its managers also share the same objectives.

A 2013 CFA Institute survey suggested that members see assessing performance over periods that are more closely aligned to clients’ investment horizons (and then deferring that compensation to increase the term further) as the optimal route to alignment of investment manager and client interests. Since that time, regulation and market practice has evolved such that few of the stakeholders that we talked to for this report now complain about the misalignment between clients and investment managers in relation to the term over which compensation is determined and paid out.

Read more in our report.