Fees paid to external investment managers and brokers now average around 110 basis points compared with around 65 basis points in 2002. Why? One of the main reasons is investors’ focus on ‘alpha’ which has increased their demand for alternative assets such as property, hedge funds and private equity.

As more and more pension funds are finding out, such investments do not come cheap. Hedge funds typically charge an annual base fee of 1-2 per cent on the value of committed capital, plus a 20 per cent performance fee. Private equity funds operate a similar fee structure. By comparison, traditional long-only managers charge fees which are often below 50 basis points.

Of course, since 2002 many pension funds have adopted a core-satellite asset allocation model which has meant underpinning their portfolios with a large passive holding, designed to capture market returns cheaply. Some commentators argue that instead of surrounding this core investment with satellite strategies run by expensive boutiques, investors should look to exchange-traded funds which cover alternative assets such as property and commodities at a lower cost.

Watson Wyatt contends that investors are unwittingly paying their alternative asset managers ‘alpha’ fees for ‘beta’ exposure, since the main driver of returns in recent years has been the strength of the markets. This has encouraged investment managers to leverage their portfolios to boost returns, which means that investors are often paying for ‘leveraged beta’, ie, market returns multiplied by borrowing.

“This is obviously a good deal for investment managers, but not necessarily for their investors,” observes Paul Trickett, European head of investment consulting at Watson Wyatt, who maintains that fees are currently too high for the value they deliver.

The research identifies a number of “flaws” in investment manager fees, including:

• Base fees are calculated on an ad valorem basis which encourages asset gathering and can undermine performance;
• Annual performance fees can amount to a free option for the manager, as the upside is uncapped but the downside is limited to the base fee;
• Fees can also be paid on money waiting in cash to be drawn down for investment;
• Many leveraged property managers charge fees on the gross exposure rather than the committed capital.

Most pension funds achieve hedge fund exposure through a fund of hedge funds which might charge a 1 per cent annual base fee and 10 per cent of net returns as a performance fee on top of the fees levied by the underlying managers. This means that a staggering 95 per cent of the alpha is paid away in fees in a scenario where the manager generates a gross annualised return of 15 per cent!

One might well ask what is the point of diversifying out of mainstream markets and into supposedly uncorrelated assets if returns are almost completely eaten away by

management fees? And given that the stock market crash caused by the bursting of the dot.com bubble in 2000 was supposed to have heralded a new awareness of management fee levels, it is ironic that fees have risen instead of falling over the last five years.

According to Watson Wyatt, an ideal fee structure should have a low base to cover costs and a performance fee which should be calculated over longer periods (three to five years) and have hurdles rates. Total fees should never be more than 50 per cent of alpha and fee structures should not be standardized across the industry in view of the increasing diversity of investment strategies and mandates.

In future [volatile market conditions], says Mr Trickett, active managers that wish to win pension fund money will need to offer them “a fairer deal”. One suspects that this fairer deal is not going to materialize without investors fighting hard to get it. The question of whether investment banks have the so-called “fiduciary heritage” to look after pension fund money can be applied equally to hedge funds, private equity firms and real estate managers.

Investors must start asking tougher questions of their consultants and asset managers. For instance, is the hedge fund investing a portion of its own money in the strategy? If not, should it be avoided? Also, are pension funds taking a close enough interest in how funds of funds select and monitor their underlying managers?

After all, at the end of the day there is no such thing as a free lunch – at least not for pension funds.

Henry Smith, editor
henry.smith@ft.com