If you pay for a service you expect to be delivered a service. But research shows that active funds are consistently failing to deliver. Investors have two choices:
- Buy the market (cheaply): A "passive" fund whose value matches a whole stock market index, like the FTSE 100 or the S&P 500, charges very low fees because its job is simple and mechanical. Funds charge as little as 0.07% for this service and can reliably deliver close tracking of the index.
- Beat the market (more expensive): An "active" fund that hires experts to outperform an index, like the FTSE 100. In return for higher fees the fund uses their expertise to boost holdings in "good" companies and reduce holdings in "bad" companies. The experts, if they do their job right, will correctly identify the good and bad companies and the return they generate will be better than the market. If they are paid to beat the FTSE 100 then if the FTSE goes up 10% in one year their fund should go up by more than 10%. Active funds on average charge 1.3% of the amount invested per year, usually as a flat fee.
Unfortunately research shows that the majority of active funds consistently fail to beat their benchmark over the long-term. In other words, most of the time investors are paying a fee for a service which they do not receive.
Who Is Fidelity?
Fidelity is a global investment company which is privately owned and which employs 45,000 people. They produce and manage their own funds, with a total of over $2 trillion under management in mutual funds. In the US they are the primary record-keeper for people's self-managed pensions (called 401(k) plans) which helps explain why they have over $6 trillion in customer assets under administration. In the UK they have over a million clients according to their website and globally they have 26 million customers. In the industry they're known as "Fido".
So, in short, Fidelity is big. When Fido makes an announcement people listen.
They have announced that in 2018 some of their active funds will adopt a performance-based pricing model.
What is Fido Planning?
Brian Conroy, who is president of Fidelity International, said:
"We want to demonstrate real commitment to our active management capability. We will move away from a flat fee model and get paid according to how well we do for our clients."
and that active fees are a
"challenge the industry can no longer duck and has to tackle head on... only active managers who provide demonstrable value will thrive"
The reason why a massive fund manager like Fidelity is changing its fee structure is that investors are getting the message about underperformance. Passively managed funds grew at four and a half times the rate of active funds in 2016 and now manage just under $7 trillion according to the FT. Furthermore this research found that this growth is accelerating, more than doubling from 8% in 2015 to 18% in 2016.
So far Fidelity has not said exactly what the fee structure will be, only that they will be available as a new share class across all Fidelity's equity funds from Q1 2018 at the earliest. They also don't like the term "performance fee", calling it a "fulcrum fee" instead.
What Is a Fulcrum Fee?
Most active funds operate with a flat fee. If you invest £10,000 and the flat fee is 1.3% per year you will pay £130 each year to the fund manager whether they beat the index or not. The fund manager maximises their profit by increasing the size of the assets they manage. 1.3% of a billion is better than 1.3% of a million. Performance affects assets under management indirectly because people flock to funds which have outperformed recently.
A performance-related fee shares the risk of underperformance with both you the investor and the fund manager. This is because their fee depends directly on their performance.
Orbis Access, an active fund manager, already has a performance-related fee. They go to great pains to explain how their fee works on their website. Essentially this is like the story of Joseph and Pharaoh from the Book of Genesis: interpreting Pharaoh's dream as seven years of plenty followed by seven years of famine Joseph advises Pharaoh to store grain in good years. Then when famine hits Egypt the stored grain avoided famine. Similarly, Orbis has a reserve fund that is filled during good years of outperformance which then reduces losses with investor refunds during bad years. Crucially, Orbis also pays itself from this fund. If Orbis' fund managers screw up and underperform their fee will fall.
As Dan Brocklebank, director of Orbis UK, said in an interview with PensionCraft this model aligns the interests of investors and the fund manager. For example active fund managers notoriously trade too much and end up paying too much in transaction costs with their brokers. Flat fee managers bundle these costs into your management fee so they don't have a strong incentive to reduce their transaction costs. However Orbis is feeding from the same trough as its investors, so it does care about transaction costs and tries extremely hard to keep them to a minimum.
By putting its own income at risk a fund manager is demonstrating confidence in its ability to choose stocks that will beat their index.
If a flat fee fund manager wants to increase its profits it can do this most easily by increasing the amount of money it manages. It can do this by hiring more marketers and advertising more. Or it can cut costs. Neither of these benefit investors in any way as they still have to pay their fixed fee. In contrast the primary means by which a fund with performance related fees increases its profit is to perform better. Boosting the amount of money they manage helps but multiplication of percentage fee by assets work best if they generate good performance.
What Are The Drawbacks of Performance Related Fees?
Performance related fees are commonly used by hedge funds but the benefits and drawbacks depend on the shape of the fee structure. The traditional performance related fee structure for hedge funds is "2 and 20": investors pay 2% of the investment amount per year whatever happens. If the fund makes a profit they take a fifth of that upside in fees. Hedge funds differ from typical pension funds or investment funds because they don't have a benchmark, they just aim to get the best return possible. They aim for absolute return not relative return versus a benchmark index. Unfortunately hedge funds are out of reach for most investors because they are targeted towards the ultra-rich and by rich we mean people with yachts and mansions.
If we look at a picture of fund return (x-axis) vs fee (y-axis) below the flat active fee is shown in green. It's flat because you pay the same amount whether the fund outperforms the benchmark or not. The passive fee is in blue and it is much lower than the active fee. Usually the passive fund tracks within a few tenths of a percent of the benchmark, because that's the job of the fund.
What Orbis does, and what Fidelity says it is planning to do is to introduce performance related fees that look like a hockey stick. If performance lags the benchmark fees are lowered down to a minimum value, the fee floor, which should be, but may not be, zero. If performance is strong fees rise up to some maximum value, the fee cap. The drawback of this structure is that if performance is extremely strong you may end up paying a fee that would be higher than the flat fee. However evidence shows that most funds fail to beat the benchmark at all over the long-term, so we should worry more about fees given underperformance as this occurs most often.
The aspect of performance-related fees that we like most is that they are simply more honest. If the fund manager believes that they can do their job and beat the benchmark they should be willing to put their own money at risk as well as that of their clients. Fidelity have suggested that their fee structure cap and floor will be as shown below. The fee floor will be 0.45% for performance 2% or more below the benchmark rising to a cap of 0.85% for 2% outperformance. This is far less radical than Orbis whose fee during periods of underperformance is zero, or even negative if it reimburses investors from its reserve fund. Investors may question why they are paying fees twice those of a passive fund for performance 2% lower than a passive fund during periods of underperformance.
