The reality is that few fund managers consistently out-perform the markets yet more attention is paid to the structure of performance fees than any other fees within a fund. This is understandable given performance fee complexities and the multitude of features such as high watermarks, hurdles, triggers, ratchets, resets, series and equalisation, duration, the ability to exclude certain income and expenses from the calculations – and combinations thereof. Clearly there is no shortage of innovative ways to structure performance fees but as per Thoreau, simplicity may be the best policy in this regard.
For most fund managers looking to build a long-term sustainable business and assuming reasonable management fees, the focus should be more on the overall cost structure of the fund and their own operations with performance fees being a bonus. The exception to this being those fund managers who do manage to consistently out-perform markets and have a reasonable expectation that they will continue to consistently earn performance fees. Keeping fund costs low may even allow fund managers to have higher management fees as long as total fund expense ratios are kept at reasonable levels.
This necessarily entails paying careful attention to the fees of service providers. Paying for large brand-name providers seems to be an easy option but is it in the best interests of investors and the manager? Managers naturally have a strong focus on performance and maintaining a low cost structure can assist with their performance. It is also commonly said that the big brand-name providers don’t always provide the best service, so the question must be asked why managers and their investors put up with high fees and poor service. Branding seems to play a large part of this, and of course is an important consideration but is it necessary for all providers to be large branded firms? Especially since so many large well known organisations have failed – consider Northern Rock, Lehman, Arthur Anderson etc.
Bigger may not be safer
Some managers may prefer larger providers as they want to ‘tick the box’ and take the ‘safe’ option to keep investors happy and of course some investors may prefer certain service providers to keep their due diligence to a minimum. These perceptions need to be questioned especially in light of the preceding comments about bigger not necessarily being better – or safer for that matter. Additionally, are the investors better off if the fund has to pay higher fees or if there are other indirect costs such as being exposed to service providers’ outdated legacy systems or if the fund manager’s time is taken up dealing with poor service rather than focusing on investments?
Selecting service providers based not only on branding, but also on compatibility, technology, expertise, service levels and cost (direct and indirect) can help managers differentiate and ultimately attract the attention of investors. Managers should be able to demonstrate why they chose a specific provider and not merely follow the crowd. Most boutique fund managers have typically broken away from large banks or firms when they first launched. It seems only natural then that they would look to appoint boutique service providers who have done the same and are more aligned with them and are typically more accessible, more flexible and more cost effective.
As the more significant recurring non-manager fund costs tend to be prime-broker/custody, fund administration and audit, we will focus on these. For custodians and auditors, one can easily see that it is crucial to have reputable branded organisations as providers. Who would entrust a relatively unknown entity to hold assets of the fund or to opine on the financial statements of the fund?
Without going into detail about counterparty risk, these entities need to have significant scale and generally global operations to fulfil their duties – that much is clear. On the other hand, fund administrators have compensating checks and balances in place as they must continuously reconcile to the prime-brokers/custodians as well as the fund manager and their work is ultimately audited every year by external auditors as well.
A changed landscape post-Madoff
It is always useful to compare Europe to the US and Asia. Until Madoff, most US firms had third party custody/prime brokerage and audit (unlike Madoff) but still performed administration internally or used the services of their local accountant to assist. Clearly the branding of the firm providing the role of fund administration, if there was one, was not seen to be as important. Madoff changed the landscape for fund administration in the US and a plethora of boutique independent fund administrators have sprung up in response to the growing demand for their services. In Asia, the operating model seems to closely follow that of best practice in Europe in that fund administration has typically been outsourced to an independent firm. It seems that boutique fund administration providers are gaining in popularity across the board as they offer more competitive pricing, have the latest technology and are more focused on providing high quality service.
Ultimately fund administrators serve as book-keepers and transfer agents of the fund and ensure the NAV is independently calculated – vital functions to be sure but as long as the fund administrator has a good reputation, sound control environment and acts independently, that should be sufficient. Fund managers must naturally perform proper due diligence on their service providers, but fund administration seems to be one area where costs can easily be contained.
Regarding performance fees, a few key questions can assist with structuring these such as – how are competitors charging? What is the optimal investment timeframe and should the performance fee be aligned with this? What performance fee features will be selected such as hurdles, triggers and/or high watermarks? Can the administrator’s systems properly calculate the fees without resorting to spread-sheets and manual calculations? What makes sense to the manager and to investors and is it fair? Another consideration is who the target investor base will be and whether there will be different share classes to accordingly cater for differing fees and/or terms for these – for example, retail, wholesale and institutional investors. Ultimately though, performance itself is paramount and one should not lose sight of that. There is no ‘one size fits all’ and performance fees is an area which leads to much discussion and where investment managers can be creative and differentiate.
There will always be a balancing act to structure performance and management fees so that they adequately incentivise the fund manager and at the same time do not detract from investors’ willingness to invest. Service provider fees should be more straightforward – they need to be minimised. Investors need to be more proactive in understanding not only the headline fees of the fund manager but also how the fees of service providers impact on their fund and their returns. Ultimately for investors, it is their investment and they should have a say in this regard. As for fund managers, there is a distinct advantage to reducing service provider fees as by keeping fund costs, both direct and indirect, to a minimum, this can enhance their returns.
Brian Taitz is Managing Director and responsible for the day-to-day operations of Charter Group Fund Administration Ltd. He founded and managed a successful market-leading fund administration business in Sydney before relocating to London.