Managers’ fees are not at the top of the priority scale in the fund sponsors’ selection process. But at a certain point in the hiring process, fund sponsors tend to negotiate fees. As a result, for most asset classes, actual fees paid by fund sponsors are often less than investment manager’s published fees. However, in the past three years the gap between published and actual fees for many of the asset classes has narrowed, particularly in the larger account sizes.
These are some of the key findings of the 2000 Investment Management Fee Survey conducted by Callan Associates of San Francisco to provide both fund sponsors and investment managers with an up-to-date report on fee payment practices, uses and trends in the US institutional investment market. “Investment management fees have been a topic of discussion in the institutional investment community for many years,” reads the executive summary of the survey. “Our last report includes important comparisons with a similar survey we conducted in 1997.”
The first key finding is that fees have become slightly more important to fund sponsors over the past three years. But fund sponsors still rank the importance of the manager’s fees in the middle of the priority scale, when conducting investment manager due diligence. Fees become increasingly important – according to Callan – as an investment firm advances in the selection process. Fund sponsors reported that they negotiate fees with more than two-thirds of their investment managers. Public funds most frequently enter into fee negotiations with their investment managers during the hiring process.
Other findings about standard industry practices show that it’s fair to pay fees quarterly in arrears. It’s becoming increasingly common to calculate these fees not on a quarter-end basis, but based on an average of month-end values. Although often discussed, performance-based fee arrangements are implemented infrequently. Investment managers change fees no more frequently than every three years.
A peculiar finding is that investment managers reported annual growth in fee revenue to be higher than what fund sponsors perceive it to have been over the last few years. On the other hand, fund sponsors perceive pre-tax profit margins to be lower – and in 1999 significantly lower – than the actual results reported by managers.
Fund sponsors and investment managers agree that, for all major asset classes, roughly half of the revenues generated are allocated to cover portfolio management costs; less than one-quarter are paid out as a performance bonus to the portfolio managers, with the remainder assigned to the firm’s profit margin. These profits have risen, while break-even costs have declined, thanks to economies of scale with increased assets under management and to technological improvements.
One effect of the manager consolidation trend is that investment firms now often manage multiple accounts for individual fund sponsor clients. But surprisingly, according to Callan’s survey, more than one-third of these multi-mandate relationships do not incorporate any fee discounts; this figure is up from one-fifth of the respondents three years ago. For the other two-thirds, the most prevalent discounting practice continues to be to calculate individual product published fees and apply a discount to the sum of all of the individual fees.
Talking about the difference between published and actual fees paid to investment managers within individual asset classes, according to Callan “it is influenced by: (I) an individual product’s performance and risk characteristics; (2) the maturity of the product with respect to its historical use by institutional investors: (3) marketplace supply and demand forces; (4) the length of the relationship the manager has had with the client; (5) the size of the individual mandate, with larger accounts receiving greater discounts”. When instead looking at fee differentials across asset classes, Callan points out that they are influenced by a variety of factors, including “(I) where the product falls on the capital market line; (2) the maturity and/or relative efficiency of the asset class; and (3) supply and demand forces in the marketplace”.
Callan compared the fee responses in this year’s survey with one conducted in 1997 and found that, overall, the gap between published and actual fees for many of the asset classes has narrowed, particularly in the larger account sizes. “On average, the managers’ published fees have declined, while most actual fees paid by fund sponsors have declined marginally or remained flat for smaller accounts and increased for larger accounts. Emerging market equity fees have declined dramatically over this period. The sharp drop may reflect a reduction in costs of managing emerging market assets and/or a higher unused capacity of assets in the wake of the 1998 crisis”. In more detail, for global emerging equity markets mandates, published fees have declined as much as 30%, while actual fees have remained flat. For US and non-US large cap passive equity mandates, published fees’ decline in some cases has been up to 50%; while for the US broad market passive fixed income mandates, fees are relatively unchanged. For US large cap active equity mandates, published fees have declined 10%; actual fees have declined also 10% for smaller accounts, but increased 4% for larger accounts. Published and actual fees for US small cap active equity mandates have declined by an average of 5% for small to medium accounts; increased of 4% for larger accounts. “The latter trend.” comments Callan, “no doubt reflects the high demand versus limited supply of small cap products, particularly for larger accounts”.
The biggest issues or concerns regarding fees that fund sponsors declared are: (1) keeping costs in line; (2) the use of most favoured nations clauses; (3) manager – rather than client – initiated fee discussions; (4) fees versus returns.
Investment managers’ most frequently noted concerns about fees include: (1) whether competitors are “buying” the business; (2) consistency of fees across the globe; (3) the use of most favoured nations clauses; (4) lower fees versus increased costs.