The latest industry transition is to reduce or in some cases completely remove the annual management fees of an actively managed fund but to include performance fees i.e outperform passive benchmarks before charging fees. This is in direct response to the rising popularity of low-cost passive investment instruments such as ETFs and ETPs.
We are in agreement that fees should be competitive since they eat into investment returns.
However, two underlying assumptions are typically made with regard to the active vs passive debate, which I aim to show are inherently mistaken:
- An active manager’s performance can and should be compared to that of a passive benchmark
- Low-cost passive investment instruments are a legitimate alternative to actively managed investment funds.
I address each in turn below:
- The inherent flaw of pure passive benchmarking
The inherent flaw in benchmarking to a market capitalization weighted index is that it focuses an investor’s attention on relative performance without due regard to risk. This is an important point. An active manager is paid to manage risk, which a prudent investor would define as the potential of permanently losing one’s invested capital.
By managing risk, according to the fund’s mandate, a good fund manager should be able to outperform an appropriate relative benchmark – on a risk-adjusted basis – over full market-cycles (typically 5-7 years). A better way, in our estimation, to measure performance is to measure the performance of similar actively managed funds, net of fees and over full market cycles on a risk-adjusted basis. Furthermore, the best way to measure an investment’s performance, in your opinion, is to measure it against your investment goals.
- The implicit risk of passive investment instruments
There are various hidden (or implicit) costs contained in passive investment instruments that investors should take into consideration when assessing overall costs, which they typically do not see in fee quotes, but which we’ve already discussed. The main implicit risk, which we have not discussed, but have alluded to, is called investment valuation risk.
Passive investment instruments, such as market capitalization weighted index-trackers (eg. MSCI World Index ETF) are able to keep costs low by not giving any due consideration to investment risk. This implicit risk should be seen as a cost (not contained in the explicit low fee quote, typical with passive instruments). Therein lies the rub.
As the prices of the underlying companies invested in by ETFs and active managers rise, they can rise to levels in excess of their intrinsic value (price dislocation). This increases the potential of permanently losing one’s invested capital as prices revert downwards to the companies’ intrinsic value, which occurs suddenly or over time as information gets disseminated throughout different sections of the market (price to intrinsic value reversion).
A good quality active manager would reduce the position sizing (i.e manage the risk) when the price of a holding exceeds its value, whilst an ETF would be forced to do the exact opposite, i.e increase its position sizing in order to more accurately track the benchmark.
Increasing exposure to an asset as it becomes riskier is counter-intuitive.
Conversely, an active manager would want to buy an asset that’s worth R1 for R0.80 and would want to buy more when that same asset sells for R0.50. This reduces the risk of permanently losing the investor’s capital. An ETF index-tracker would be forced to do the exact opposite.
It naturally follows, in our opinion, that most market capitalization weighted indices and their trackers are not suitable alternatives to good quality actively managed investment funds or for benchmarking.
The performance fee debate
With regard to the debate on charging performance fees only relative to charging an annual management fee, my view is that the former holds significant dangers to investors and also to governance.
The natural drawback, typically, with performance fees is that outperformance is measured even during times of negative performance. Inherently an investor can lose money and still be obligated to pay the manager an outperformance fee.
Some of the dangers, not noted in mainstream investment articles, with charging only a performance fee coupled with extremely low or no annual management fees are:
- Changing the benchmark. The manager may be tempted to change the benchmark in order to more easily charge a performance fee. This may actually lead to higher fees than were previously the case.
- Increasing business risk. A good fund manager underperforming relative to a passive benchmark for a protracted period (say 3 years) due to investing in businesses with normal but deep business cycles (energy, semiconductors, mining, shipping etc.) may lead to the manager experiencing low revenue and income over that period. This may result in the business not being able to retain key investment personnel in spite of the investments made containing significant potential for good through the cycle performance.
This, in turn, may lock-in the temporary underperformance of the funds, as key investment personnel leave the manager. An example of a manager where this could have occurred, were they to charge only performance fees, is the fund manager Contrarius.
At one stage the Contrarius Global Equity Fund generated negative performance in excess of -25% over a 12-month period. We had various teleconferences with their investment team and their management over this timeframe and established that investors understood that this was temporary and, therefore, did not withdraw their capital from the fund and the business. The fund manager as a business, therefore, remained intact.
Subsequent to said temporary underperformance the fund managed to achieve in excess of 70% over a one-year period and now stands at 13.6% compounded per annum over the past 5 years, net of all management fees and as at 4 October 2017.
Given these risks, we are of the view that a fund manager should be fairly compensated for achieving good long-term, risk-adjusted performance. Being fairly compensated results in long-term investment team retention, and lowers business risk, which is separate from a particular investment or investment product’s risk.
It is important to note that certain ETFs and ETPs like market capitalization weighted index-trackers give no consideration to the governance of the underlying companies they invest in. As long as the prices of those companies rise, they will be forced to buy more of those companies.
In the case of Enron, for example, ETFs were buying more when good active managers were steering clear, which resulted in more investors losing capital than ought to have occurred. Low-cost passive investment instruments that track the performance of passive benchmarks are, by their very nature, governance and risk agnostic. Should one not subscribe to this view the only other argument one can make is that some of them may even be viewed as poor governance and high-risk promoters.
In a different vein, regarding the governance of fund managers and low fees, a good quality fund manager should conduct a thorough due diligence on all the underlying managers and individual holdings of its funds, before investing. Not only is this a characteristic of good governance and good active management, it actually promotes the long-term sustainability of the underlying holding.
For example, by holding an individual company, the fund manager can vote against granting the authority for that company’s management to issue shares when the shares are trading at price levels below its intrinsic value as this would be value dilutive to existing investors, or it may vote against the appointment of an unethical auditor or director. Passive instruments do not have the same luxury or value addition mindset.