Top-level industry data suggests that the active strategies overseen by mutual fund boards are facing an uncertain future as passive products continue to attract a disproportionate share of flows and ongoing fee pressure chips away at their margins. As a result, responding to fee pressure continues to occupy an ever-growing share of fund directors' time and energy. And directors aren't just having to consider asset class peers and passive options when contemplating fees; they also are factoring in other investment vehicles such as separately managed accounts and collective investment trusts that can deliver active management.
According to a report from PwC, the U.S. mutual and exchange-traded fund market is expected to grow 5.6% annually from 2018 to 2025, down from a pace of 8.7% from 2011 to 2018, while the spilt between active and passive assets will move from 64%/36% to 50%/50%. At the same time, active portfolio total expense ratios will continue to decline from an average of 80 basis points in 2011 to 64 basis points by 2025. The result, according to PwC, will be up to a 20% decline in the number of management firms, a 14% net reduction in the number of products, and a growing concentration of assets in the hands of the five largest managers, from 55% in 2018 to 64% in 2025.
One of the ways that firms have come up with to boost the credibility of active management, and possibly better align the managers' success with that of fund shareholders, is the use of fulcrum fee pricing models. This is a type of performance-based fee structure through which a mutual fund’s management fee increases or decreases in proportion to the fund's level of outperformance or underperformance relative to a benchmark over a specified period of time.
Despite a limited supply of products in the market currently, fulcrum fees are increasingly being vetted as a possible strategy for combating the ongoing migration to passive products and the resulting fee pressure on active managers. The general concept, and inevitable marketing pitch, of aligning advisers and shareholders so that "we only do well when the shareholders do well" will ensure that fund boards will increasingly be asked to consider this fee structure.
Current asset gathering can be described as modest, at best, with just two new portfolios—one each from AB and Allianz—amassing just over $100 million in assets as of Sept. 30, 2019, nearly two years after launch. Indeed, much of the headway has been outside of the retail investment marketplace. For fund governance professionals to fully gauge progress, they must look to the institutional market, in the United States and the rest of the world.
It Starts with Institutions
Institutional investors have a complicated history with performance fees. In 1986, the Department of Labor approved the use of fulcrum fee structures by private pension funds. Shortly after, a survey of 1,500 pension executives indicated that 43% preferred managers to charge performance-based fees. However, since the active asset management industry was at the start of an extraordinary growth cycle, there was little incentive to offer fulcrum fee products. In the intervening years, a growing percentage of institutional investors have incorporated hedge funds and other alternative strategies into their portfolios.
Currently, according to the Callan 2017 Investment Management Fee Survey, about 80% of institutional investors use performance-fee arrangements for hedge funds and private equity, always or frequently, while the majority never use these arrangements for traditional asset classes.
Nearly 35 years after passage of the DOL rule (the SEC passed a similar rule in 1985 for qualified investors), the fee spotlight now shines brighter over the '40 Act space. Mutual funds are now a mature vehicle, and fee pressure is forcing providers to pursue new pricing strategies in order to continue growing. Though U.S. institutions have not yet embraced the pricing model, the perspective toward performance-based fees may be changing faster in Europe and Asia.
In Europe, much of the discussion regarding fulcrum fees, or performance-based fees in general, is related to implementation of Markets in Financial Instruments Directive II (MiFID II), an ambitious post-2008 regulatory revision aimed at better protecting investors.
Some firms, most notably Fidelity Investments, believe the spirit of MiFID II calls to align the interests of product/service providers and investors, including changes to how investors are charged for the value they receive. To address this, Fidelity International implemented a fulcrum fee pricing structure on a range of funds offered in Europe. So far, asset gathering has been tepid, but the firm’s adoption of this pricing serves as an opening salvo in a much larger debate over how to innovate active management pricing.
Perhaps the most compelling example of the growing interest in performance-based fees among institutions comes from Japan. In April 2018, the Japanese Government Pension Investment Fund (GPIF), the world’s largest retirement portfolio with $1.4 trillion in assets under management, instituted a new system through which it pays active asset managers based on their performance. Under the system, asset managers that fail to beat their benchmarks receive fees equivalent to a passive strategy in the same asset class. In order to earn the fixed-rate fee, the managers must beat the benchmark by a pre-negotiated level; and they must exceed the alpha target in order to earn higher fees. As an indication that the new system may be helping GPIF achieve better value for money, payments to money managers fell 40% for the fiscal year ended March 31, according to GPIF's most recent annual report.
Fund providers looking to improve receptivity of the structure in the retail market must address the unique concerns of distributors and advisors. Shortly after their launch, the new fulcrum fees funds offered by AB and AllianzGI started earning placement on distributor platforms, including those of Bank of America Merrill Lynch, Morgan Stanley, LPL Financial, Charles Schwab, TD Ameritrade, and Pershing. While this is an accomplishment, it is far from a guarantee that assets will follow.
In general, feedback from distributors suggests they are open to the idea of fulcrum fee funds, but some issues need to be cleared up before the products can earn widespread adoption. Speaking at the Securities Industry and Financial Markets Association annual meeting in 2018, Sandy Bolton, the head of managed investments at Bank of America Merrill Lynch, said: "I think there’s some interesting product development going on. You have the fulcrum fee funds. AllianceBernstein’s FlexFee funds are an interesting concept that hopefully, someday would perform really well and draw a lot of attention and flows. But right now, it kind of just seems like a good idea. I’m not sure how we would ever use that in a model portfolio."
Gaining the support of the distribution platform is only part of the equation, as advisors have their own concerns about the risk and rewards of fulcrum fee funds. Our research has revealed that advisors have a number of questions when it comes to use of fulcrum fee products in their portfolios:
- How do I explain the fees to clients? A review of available materials and tools indicates that providers are making a concerted effort to educate advisors on their fulcrum pricing structures. While these educational resources might allow interested advisors to quickly ramp up their understanding of the fees, explaining the fees to clients is a different matter. Recreating the math behind how a particular fee was determined can be very complicated, and the misgivings of advisors to broach a complex fee discussion with clients are enough to thwart other efforts to gain distribution. The client conversation is where asset managers really need to offer support, as advisors will not utilize fulcrum fee funds if they don’t feel confident in their ability to explain them to clients.
- What if there is a pricing mistake? Due to the complexity of the fee calculations, this is a very real concern. Errors can cause reputational damage to both the asset manager and the advisors who placed clients in the products. And, with regard to fulcrum fee funds, this scenario is not without precedent. In 2006, the SEC ordered five mutual fund companies—Dreyfus, Gartmore Mutual Fund Capital Trust, Kensington Investment Group, Numeric Investors, and Putnam Investment Management—to return more than $7 million in miscalculated and overcharged performance-based fees to investors from the period between 1997 and 2004.
- Do performance-based fees compel managers to take more risk? Research has been done comparing the performance and risk-taking of fulcrum fee funds to their non-incentive fee counterparts in the same category. In 2008, Lipper performed research related to the performance and risk-taking of fulcrum fee funds for the 10-year period through 2007, finding that fulcrum fee funds outperformed their classification medians but exhibited higher standard deviations. Lipper revisited this research four years later after the financial crisis. This time it found that over the 10-year period from 2003 to 2012, funds with incentive fees underperformed their classification medians over one, three, five, and 10 years and exhibited higher standard deviations over three, five, and 10 years. Additionally, unlike in 2008, the funds posted lower risk-adjusted returns (as measured by the Sharpe ratio) compared to their non-incentive fee counterparts over three, five, and 10 years.
It is important to note that across these time periods fulcrum fee portfolios have accounted for just 3% of funds and 6% of industry assets, the vast majority of which were managed by Fidelity and Vanguard. Thus, at this point, it’s difficult to draw any concrete conclusions about the risk-taking behaviors of fulcrum fee funds managers.
Changing the Conversation
When it comes to the use of fulcrum fees as a way to revive active management, the concept is still in its early days. As the conversation continues and more industry players offer their insights, understanding of the potential of fulcrum fee pricing in the retail market will progress. Among those with the greatest conviction in performance-based pricing for active management is Peter Kraus, the former CEO of AB who oversaw the development of the AB FlexFee series. Since leaving AB, Kraus has launched Aperture Investors, which directly links management fees and manager compensation to portfolio performance.
In developing the pricing of its funds, Aperture first determined the average fee for an ETF in the same category to use as the base fee, then applied up to a 30% performance-linked fee, citing academic literature indicating that the fair price of alpha is about one-third of the excess return. Meanwhile, the firm defers half of manager performance compensation for two years, and the payout only occurs if the fund’s performance record remains intact over three years.
Currently, views on fulcrum fees are somewhat polarized, and fund boards will be asked to weigh both the pros and cons of adopting such a performance fee. Proponents cite better alignment of manager and investor interests, and the arrangement does reward managers who achieve sustained alpha. Opponents argue that they introduce increased complexity, and therefore reduced transparency, to the cost of mutual funds, and that they have the potential to incentivize managers to take on too much risk.
That the fulcrum fees are currently viewed as incompatible with model-based product delivery, where so much of the industry is moving, should also give pause. While both perspectives have validity, neither offers a complete assessment of the pricing model’s potential in the retail active fund market.
For now, the industry is still benefiting from the longest bull market in history, which has likely stymied adoption of the fulcrum fee structure. However, when it inevitably comes to an end, the impact of lower management fees on active managers' bottom lines will become more pronounced, increasing the urgency to find a solution. This could compel more managers to transition to a fulcrum fee pricing structure, particularly mid-sized firms that will feel the squeeze from all sides.
Any move to fulcrum fees will be a slog, not a sprint, and initial success will not be measured in new assets. Rather, the goal will be changing the conversation from how much more expensive active management is relative to passive to a dialogue about how both styles can provide good value for money depending on the objective of the investor.
Bob Kennedy is a relationship manager for FUSE Research Network, which provides data and consulting services to the investment management industry—including to mutual fund boards. He works closely with FUSE clients to ensure that they achieve their strategic and tactical objectives, and is also a contributor to the FUSE BenchMark series and other FUSE research.
 Mutual fund outlook: The time to act is now, PwC, July 2019.
 "Performance-fee move bears watching," Pensions & Investments, Aug. 5, 2019.
 "GPIF's alignment push sparks sharp drop," Pensions & Investments, July 22, 2019.
 Wenik, Ian. 2018. "Merrill's Model Push Means Funds Must 'Fit Cleanly'," CityWire, Oct. 4, 2018.
 "To tackle the rising popularity of passive investments, active managers are turning to performance-based fee models. But will it work?" CityWire, Feb. 12, 2019.
 "Funds charging performance fees outperformed: But Lipper study finds the funds take on more risk," InvestmentNews, June 16, 2008.
 Performance Incentive Fee Funds Post Downturn, Thomson Reuters Lipper, September 2012.
 "This New Asset Management Firm Will Cut Your Pay If You Don't Beat the Market," ContinentsNews.com, Nov. 7, 2018.