Fidelity’s high-profile move to offer no-fee index funds is shaking up asset management, this time in the institutional market.
Institutional investors are using Fidelity’s recent launch of no-fee funds for retail investors to negotiate hard for their own fee deals. Quantitative firm Analytic Investors, which Wells Fargo Asset Management acquired in 2016, and other asset managers are feeling the pressure to eliminate base management fees — or keep them very low — and instead charge performance fees.
Fidelity has attracted more than $1 billion since it launched index funds with zero management fees and no investment minimums this summer.
“The hoopla around Fidelity going to zero fees for some funds basically reset the table even on the institutional side,” said Harin de Silva, president and portfolio manager of the Analytic Investors team at Wells Capital Management. “Until recently I would almost never be in an institutional meeting where somebody would say, ‘How about a zero fee?’ Now people are increasingly comfortable with a zero-management fee and a performance fee.”
Pensions funds and other institutions are asking Analytic to eliminate base management fees on both its newer factor-enhanced — or smart beta — strategies as well as the firm’s legacy hedge-fund-like products, including long-short equity and market neutral funds. Newer institutional mandates are being priced at 10 or 20 basis point management fees and 20 percent performance fees above a hurdle, said de Silva. Management fees may go to zero, he added.
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Now that Analytic is part of Wells Fargo, the decision to offer zero-fee mandates is an easier one, de Silva said. As an independent firm, Analytic needed ongoing management fees to pay fixed expenses and couldn’t risk not earning a performance fee.
But when an institution is switching out of a low-fee product, such as a market-capitalization-weighted index fund, into a higher-priced smart beta fund, paying a manager based on performance can be helpful when arguing for the move with boards of trustees.
Having zero or very low management fees is a big change for Analytic.
“Zero means that if you have a three-year performance drought, you’ll actually make nothing for three years,” said de Silva. “If you’re part of a large organization, you don’t have to worry about payroll or health insurance. That’s not true at a small organization,” he said.
De Silva also raised concerns that big expenses, such as paying for data, would be hard to justify when performance is less than stellar.
“Say you’re going through a rough period, and you find some wonderful new data source. In the back of your mind, you’ll be thinking, ‘Can I take on another huge annual fee for data if I don’t have anything coming in and I’m worried about making payroll?’” said de Silva.
An executive at a large asset manager, who asked not to be identified, agreed that small firms are at a disadvantage in offering zero management fee structures.
“Large firms can use fees from a lucrative product to subsidize zero-fee mandates — although that can’t go on forever,” he said.
Clients of one smaller firm, $38 billion Orbis Investment Management, have been able to opt for a similar structure — a very low management fee plus a performance fee — for 12 years. Orbis also offers a zero-management fee option that then has a higher performance fee.
“There’s a fundamental gap in investment management: people don’t relate the fees they pay to the value provided by manager,” said Dan Brocklebank, head of Orbis Investments in the U.K. “We believe we should only do well if clients do well.”
Brocklebank said Orbis has developed a unique structure, though, to deal with a potential problem with performance fees — which is giving a manager the incentive to simply take risk and try for a blowout year.
“They get the performance fee paid at the end of the year, and if it doesn’t work well from there on in, that’s ok, they already got their fee,” he said.
Orbis instead puts the year’s performance fees into a reserve fund. If the manager subsequently underperforms, the reserve is there to flow back to the client.
“The structure shifts the debate right away,” Brocklebank said.
That’s because all active managers go through periods when they’re not doing well, he said. With a management fee structure, gross returns will be less than the benchmark during these periods of underperformance. But an investor’s experience is even worse because of the effect of fees.
“With our funds, it means that the return the clients experience during periods of underperformance can be better than the gross returns delivered. Our structure softens the blow,” Brocklebank said.
Even with the potential benefits for investors, Analytics’ de Silva is skeptical, however. “I’m not 100 percent convinced that this is a long-term tenable structure,” he said.