The fee structure of active managers has already been threatened by the rapid growth of cheaper passive investments and a low-interest rate environment.
But the crisis could add pressure on active managers to innovate their fee model, as it is cutting their revenues short.
Moody’s recently downgraded its rating on asset managers from stable to negative, as it expects their profitability and liquidity to suffer from the crisis.
And while active managers could outperform passive managers in the crisis, by proving their ability to manage volatility compared to their counterparts, it is unclear if they will.
Setting the ‘right’ incentives
Peter Kraus, chairman and chief executive of US-headquartered Aperture Investors, argues that the industry is broken and that it needs to be changed.
“We had [a recession in] 2000; we had 2008, in which active management could have outperformed dramatically. It didn’t,” he told Expert Investor.
Kraus believes that a major reason for this underperformance is their reliance on fixed fee models, which he says does not incentivise managers to take risks.
In fact, the opposite is true and they are encouraged to lower risk. Asset managers can earn more revenues by increasing the amount of their assets, he explains.
“[But] the more money the manager manages, the more difficult it is to perform.
“And if you incentivise the manager to own more assets, because it pays them more, then you’re incentivising the asset manager to actually underperform, or have a higher probability of underperforming,” Kraus says.
A performance-linked fee, which Aperture applies, is the solution, he believes. It rewards asset managers for risk taking and outperformance, but equally erodes their revenues if they don’t.
“What most institutional investors and individuals have done is they’ve taken so little risk that they actually can’t perform. If you run concentrated portfolios, you have the opportunity to actually create real returns,” Kraus explains.
He says that Aperture managers were able to control risk in the crisis. Its Aperture Credit Opportunities Fund (dollar denominated, institutional share class) implements a multi-asset, absolute return and long-short credit strategy and was launched in August 2019. It counts 142 holdings and returned minus 2.74% year to date and net of fees, as of end of March.
And only high-quality managers, he adds, will be able to estimate the survival of companies after the lockdowns by analysing the dynamics between their revenues, earnings and balance sheets.
The growing sustainability trend could also shape how fee models will evolve.
Lars Dijkstra, chief investment officer of Dutch investor Kempen Capital Management, believes that the crisis will most likely pave the way for sustainable capitalism.
The asset management industry is facing a paradigm shift away from short-term towards long-term environmental, social and governance (ESG) mandates, in his view.
How fees incentivise asset managers is deemed to be central in creating sustainable growth of companies and avert ESG risks, such as climate change and inequality.
Dijkstra explains to Expert Investor: “Traditional active and passive managers are, basically, part of the same problem; [they are] acting in the interests of short-term shareholders.
“You really need much more alignment of interests and incentives between asset managers and companies.”
Short-term incentives reward asset managers and chief executives to support short-term profit of companies and shareholders.
This has been found to lead to companies reducing or foregoing needed investments to grow sustainably in the long-term, as well as a disconnect between investments in the financial system and the real economy.
To promote a long-term focus and increase returns of its active asset managers, Japan’s Government Pension Investment Fund, the world’s largest pension fund, introduced in 2018 multi-year contracts and a new performance-based fee model. It includes a carryover mechanism, under which a portion of the fees are held back to even out the amount paid in the medium and long term.
The agreement of mandates between asset owners and asset managers is one of the most fundamental tools to influence long-term investment behaviour, according to Focusing Capital on the Long Term (FCLT) Global, a not-for-profit organisation dedicated to encouraging long-term behaviours in business and investment decision-making.
Aligning sustainability objectives
Dijkstra says that the future will belong to tailor-made passive (ESG-exclusion driven) and, even more important, to ‘real active’ (ESG-inclusion driven) investors.
He defines ‘real active’ investors as those who manage relatively concentrated portfolios and seek to create long-term value for all stakeholders.
“Mandates which are long term in nature – ie which run at least five to seven years – can of course be offered to clients much cheaper than the current mandates which clients can terminate every day,” he explains.
Stewardship will make a decisive difference between active and passive asset managers.
“Only ‘real active’ investors who know companies and their sectors inside out can be real sparring partners of those companies.
“Passive investors, with all due respect, can’t. They simply lack the knowledge to do so,” Dijkstra says.