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Resetting investor expectations

In part 2 of the great fee debate, it’s the investors’ turn to reassess their expectations regarding management and performance fees, and to understand what it takes to find (and pay for) top managers.

In part 1, we looked at resetting fund manager expectations in the fee debate. In part 2, it’s the turn of the investors. After reading part 1, investors might be feeling vindicated and there may have been some smiling and nodding at the shortcomings of many managers. But this isn’t a one way street and there are some expectations that many investors should be changing for their own good.

Investors need to decide if they are fee driven or return driven

Many fund managers are partly right in arguing that some investors don’t prioritise total returns, but are instead more concerned with total fees. Focussing on total returns may make sense for an individual investor, but institutional investors are equally entitled to choose a low fee business model for their members and clients. But just as high fee managers are better off not pitching to low fee investors, low fee institutional investors should be transparent and decline meetings if the manager has no chance of meeting the target fee levels. This requires investors to know what they are willing to pay for each particular strategy. It also requires investors to know what split of base and performance fees they will pay and to be upfront in asking managers to work with that.

Low fee investors need to decide how to allocate their fee bucket

Low fee investors may choose to spread out their fee bucket over all sectors, or choose a strategy that has a core of very low fee index investments with a few satellites that will hopefully deliver the most return for the fees available. This will allow the investor to spend time choosing the best managers in their favoured sectors, rather than hearing pitches from managers who have no hope of fitting into the overall strategy.

If you want to beat the index you need to deviate from the index

Some investors seem to believe a fantasy world exists where managers can consistently deliver outperformance relative to the index. As any honest manager will tell you, there is no straight line of outperformance and deviating from the index means there will likely be periods of prolonged underperformance in order to deliver long term outperformance. Many top managers over a ten year period often underperform the average for a two to three year period at some stage during the ten years. Hugging an index means getting returns equal to an index minus the fees charged.

Top managers often don’t come wrapped in nice packages

I’ll mention two managers you’ve probably never heard of illustrate this point. Allan Mecham of Arlington Value Management had $80 million under management in 2012 with 12 years of track record and 400% returns over that period, leaving the S&P 500 for dead. Two years later he had $470 million under management and has continued to post extraordinary returns. Strangely enough, Mecham isn’t closed to new funds. Despite enormous outperformance over a very long period, institutional investors can’t deal with his demand for patient capital and his lack of Wall Street polish.

The next example is Michael Burry, formerly of Scion Capital. He was previously a medical student who took up investing as a hobby then decided to start running his own fund in 2000 after successfully blogging for many years. Like Mecham, his returns were off-the-chart good. By 2004 he had $600 million under management and was turning away investors. Starting in 2005 he began to short sub-prime credit default swaps. His investors, who had seen their investments more than double in four years, were enraged that their manager had moved away from solely stock picking and began to redeem their money. By 2008, despite having made a net 489% for the original investors in under eight years, Scion Capital closed and Burry now manages only his own money.

Both of these guys seemingly came out of nowhere and were not the usual asset manager types. Both managed capital with a long term view, took on concentrated positions and invested where their reading and ideas took them with little regard for typical investment styles. Regardless of the returns, the vast majority of institutional investors and asset consultants will not deal with them. Perhaps the real issue is that investing with people like this carries too much perceived career risk for investors, who work in an environment that relies on safety in the herd.

Top managers will inevitably be closed to new funds and will sometimes return capital to protect returns

In the last 12 months, Paradice in Australian equities and US hedge funds Appaloosa and Baupost have returned meaningful capital to their investors. They believe that their future returns will be negatively impacted by their existing size. Investors need to recognise that top performance often comes in the early years when outperformance is not diluted by size. For managers that do close, new investors that come late won’t be able to invest at all.

There is both skill and hard work involved in identifying top managers

There is arguably as much hard work and skill required to select top managers early, as there is required by those managers themselves when selecting underlying investments. As a guide, less than 10% of all managers can be expected to meaningfully outperform a suitable index after fees in the long term. If investors want to have an edge over their peers, they need to be actively searching for top managers and have clear measures to identify early what outperformance looks like.

Investors need to change their managers to get meaningful change in their fees

What most investors mean when they say they want lower fees is that they want their existing managers to charge less. This is a fairly naïve position to hold. In all walks of life people would prefer to pay less, but those who truly care about the issue do something about it. If a manager doesn’t have superior performance and won’t offer low fees to retain business, the capital should be redeployed to another manager or an index fund. For top performing managers, a balance needs to be struck bearing in mind the potential manager capacity issues and the possibility of an investor’s capital being returned.

For many investors, the way they choose managers needs to be changed so that fees are always one of the first points agreed. Another change would be to run an open, publicly advertised tender process. By publicly specifying what fees the investor is willing to pay and the outperformance expectations they hold, an investor is likely to discover new managers, strategies and fee propositions that they otherwise would not have considered.

Whilst many investors would say that this is what their asset consultants are paid to do, there is clearly a breakdown in this process as there has been very little change in fee levels or manager selection in the last decade.


The average manager and investor both have many things to reflect on and expectations to change in the great debate over fees. Managers need to start taking costs out of their businesses and resetting their expectations of what investors should pay. As well as lowering base management fees and eliminating obscure fees, managers should engage with their investors more often noting when their sector is good value and when it isn’t. Investors need to be more transparent about their willingness to pay fees, and be willing to change managers in order to have a step change in their fee levels. Investors should actively encourage low fee managers to pitch to them and take action to switch to such managers where the risk and return proposition is merited.


Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. Narrow Road Capital advises on and invests in various credit securities. His advice is general in nature and readers should seek their own professional advice before making any financial decisions.

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