There has been a continual debate on how to optimally structure asset management fees. Mutual funds currently adopt asset-based fees, which is not always fair to the investors. The question is: What is the fee model that is fair to the investors and the firms?

This article explains the issues relating to asset-based and performance-based fees. It then shows how firms can develop a blended model that is fair to the investors as well.

At first glance, it is obvious that asset-based fee is not optimal for investors. The firm receives its fees as percentage of assets under management (AUM) even if it underperforms the benchmark index (negative alpha). Besides, there is no direct incentive to generate higher returns, prompting firms to “chase” asset size to generate revenue.

Consider a fund whose alpha strategies are not unique. A non-unique alpha strategy would mean that the fund is primarily generating excess returns through exposure to high beta stocks. This causes inconsistency in excess returns, as market timing plays an important role in performance. Such funds typically increase revenue by gathering large AUM through strong marketing network.

Performance-based fee, on the other hand, appears to align the interest of the investors with that of the firms.

There are, however, some issues that merit attention. One, performance-based fee model requires a meaningful benchmark that captures the underlying investment process. Two, the firm has to have a good performance measurement system that captures the alpha and the resultant performance fees.

And even if firms have best-practice performance measurement systems in place, the investor is confronted with the need to identify a fund that generates sustainable alpha.

This is no different from the present situation of asset-based model where all firms charge similar fees, forcing the investor to search for funds that generate consistent returns.

What, then, is the way ahead?

Blended fees

A blend of asset-based and performance-based fees could help moderate the problem by aligning investor interest with that of the asset management firms. Some form of this structure is already practiced by hedge funds.

To start with, firms should have a low asset-based fee, say 100 basis points. We believe that each fund should define its mandate in a measurable way to reward sustainable performance.

Suppose a fund follows large-cap style. The mandate could be to, say, generate excess returns of one per cent with a tracking error of not more than 2 per cent. In effect, the mandate requires the fund to have an Information Ratio (Excess returns divided by Tracking Error) of 0.50 or more.

Such a model could moderate the problem of a having an inappropriate benchmark, as it adjusts for the associated risks through the Tracking Error.

The model can define a participation rate of, say, 20 per cent of the excess returns over the benchmark if the fund generates the mandated Information Ratio (IR); higher IR would proportionately increase the performance fees while lower IR would decrease the fees. And to ensure consistent performance, the model can require the fund to achieve the mandate in, say, rolling three-year periods.

Conclusion

The blended-fee model appears to be fair to the firms and the investors. Importantly, firms adopting such a model signal confidence in their alpha strategies.

Besides, firms would be hard-pressed to look at their alpha fading rate — the rate at which alpha converges with the market returns or beta. This could prompt them to continually explore newer strategies and not offer same products as their peers. Such a scenario would augur well for the investors in the long run.

Of course, the larger issue still remains — if all firms eventually adopt the blended model, investors will still have to identify funds that can generate sustainable alpha.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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