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The future of active fund fees is more utility than luxury

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The future of active fund fees is more utility than luxury

My clients often ask me what I think is fair to charge for managing money, and my answer is always the same – the net return after all costs is what matters.

In that context, it is deeply disturbing that, in recent years, many hedge fund managers have earned more in fees than their investors have earned in returns. We need to put more pressure on investment managers to lower their fees. Otherwise the industry will go all-passive eventually. Let me introduce what I believe is a fair model.

To begin with, if an investment manager wants to charge a performance fee (which is fine by me), the management fee should only cover the cost of running his business, and that is before bonuses to traders and portfolio managers. To allow an investment manager to get fat on both management fees and performance fees is entirely unnecessary and grossly unfair to investors.

For an equity fund with £1 billion of assets under management (AUM), such costs typically amount to less than 0.5% of AUM, but the number can vary a great deal from case to case. In practical terms, my proposed model implies that the management fee would be reduced as the fund grows in size.

Secondly, the performance fee should only be charged on the alpha component after all other costs have been deducted. Why would you pay a performance fee on beta returns? An index fund charging a few basis points can do that job.

Let’s take an equity long/short fund with £1 billion of AUM, and let’s assume the investment manager is up 15% gross in a year where the equity market is ‘only’ up 10%. Under the prevailing 2+20 model, total fees will amount to about £45 million.

In addition to those exorbitant fees, investors will pay various other costs for a total expense ratio of about 5%. In other words, the 15% gross return has suddenly turned into a 10% net return – no better than an index fund would have done.

Now, let’s play with those numbers. Let’s assume our investment manager agrees to lower the management fee to only cover costs (assumed to be 0.5%), and let’s assume that the 20% performance fee is only charged on the alpha component. Under this model, the £45 million turns into £14 million – still enough to give the management team a more than decent lifestyle.

Our investor is the big winner, though. Instead of ending up with 10% after all costs, the net return is now a tad above 13%. Enough to prevent most from going passive.

Niels Clemen Jensen is founder & chief investment officer at Absolute Return Partners and a Citywire Wealth Manager columnist. he is the author of the recently published The End of Indexing

 

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