Asset managers are facing mounting fee pressure. What measures can they take to cope?
The asset management industry continues to struggle with the increasing pressure on fees from investors with fees falling by approximately 5% annually for most asset classes and segments, according to Casey Quirk by Deloitte. This has been largely driven by the shift to passive funds, which have seen their assets more than double since 2010 and in 2018 accounted for 22% of the US fund market, according to the Investment Company Institute. At the same time, the industry has faced mounting fee pressure from regulators. A number of new rules have been enacted around the globe to increase transparency on the cost associated with investing in funds.
Asset managers have taken a number of measures to cope with this pressure, such as introducing new fee structures, looking for new sources of revenue, and expanding their product suites. Each coping mechanism presents challenges, which should be considered before implementation.
New Fee Structures, New Challenges
Beyond simply cutting fees, some managers have turned to new fee structures to make their funds more attractive. Some have instituted unitized structures, where the fees are fixed, as opposed to traditional fund fees that rise or fall depending on the growth of the fund. Another approach is breakpoint fees, where the investors are given incremental fee discounts when their investments reach prescribed thresholds. Finally, some managers have implemented performance-based fees, such as fulcrum fees, that increase or decrease based on the fund’s performance against a benchmark. Performance-based fees may be attractive to both active managers and investors alike because the baseline fee is typically lower than the average flat management fee and ensures that investors don’t overpay in times of underperformance.
Performance-based fees are complex and investors don’t necessarily understand or trust them yet. Communications need to be clear, especially around how the fee is calculated.
The main consideration for managers implementing performance fees is how it will affect their existing infrastructure. Performance fees introduce complexity that may require new workflows and system enhancements to handle the new calculations. Additionally, managers need to consider how performance fees could affect reporting to investors and regulators. Managers must also have robust controls over the fee calculations, including close oversight of the service providers who typically carry out the day-to-day calculations. Beyond oversight, it is important to make sure the service provider can systemically support the calculations, to help avoid the risks associated with manual processes.
Although performance-based fees may make sense in the current environment, funds with these fee models have yet to gain much traction with investors. Part of the reason may have to do with investor communication. “Performance-based fees are complex and investors don’t necessarily understand or trust them yet,” suggests Charlie Rizzo, COO Americas & EMEA, Global Head of Fund Administration, Head of US Transfer Agency, CFO of John Hancock Funds. “Communications with investors need to be clear, especially around how the fee is calculated.”
Complexity often increases cost. Managers should evaluate if the benefit of the new fee structure outweighs the cost and potential product disruption to implement.
Given the relatively low success of fulcrum fees, managers should consider the impact of the additional complexity before moving ahead. As Paul Kraft, Partner, US Mutual Funds & Investment Adviser Practice Leader at Deloitte says, “Complexity often increases cost. Managers should evaluate if the benefit of the new fee structure outweighs the cost and potential product disruption to implement.” New fee models should be part of a larger strategy and not just a tactical response to market conditions.
The Securities Lending Salve
To combat eroding margins from fee compression, managers are looking for new ways to generate increased returns. A common practice by passive asset managers, securities lending is now being adopted by a growing number of active asset managers. “Securities lending presents a real opportunity for active managers. In the past year we’ve seen a number of new entrants into the securities lending market, many who haven’t lent before or haven’t lent in many years,” says David Martocci, Head of Agency Lending at Citi Securities Services.
Securities lending is not just a check-the-box exercise from a fiduciary standpoint. The level of portfolio manager involvement is really going to drive the value proposition of your program.
Securities lending is a practice where asset managers lend their holdings to other investors for a fee. According to Flowspring, funds can generate upwards of 40 basis points in revenue from securities lending, depending on the makeup of their portfolios, which can bolster a fund’s performance and compensate for reduced fee income. In addition to the potential revenue considerations, many fund boards are also viewing it as their fiduciary duty to consider securities lending. However, implementing securities lending requires firms to create the right governance to oversee the program and the service providers who deliver it. For active managers, it is critical that the portfolio managers are consulted and buy in to the idea. “Securities lending is not just a check-the-box exercise from a fiduciary standpoint. The level of portfolio manager involvement is really going to drive the value proposition of your program,” advises Martocci. The combination of fee pressure and the search for returns means that securities lending is fast becoming an essential element of any asset manager’s strategy.
Old Fund Structures Are Making a Comeback
The line between alternative and traditional asset management has started to blur. Driven by the push to increase revenue and satisfy investors’ growing interest in alternative investments, traditional asset managers are leveraging more alternative fund structures. As Kelli O’Brien, Director of Fund Administration at Citi Securities Services notes, “Asset managers need to continually find ways to meet their investors’ demands and this can mean using new wrappers to deliver their solutions.”
The move into alternative strategies requires expanding product ranges to incorporate the use of new fund structures. In the US, this has led to a resurgence of interval funds. First introduced in the 1990’s, interval funds are closed-end funds with set redemption periods. Though comprising a small overall market share, interval fund assets are on the rise. Assets under management grew by 41% to $27.5 billion in 2018, according to Interval Fund Tracker. The attractiveness of interval funds for managers is multi-faceted: they allow more investment in illiquid assets, pre-set dealing dates make portfolio liquidity management easier, and investors have shown a willingness to pay more to access alternative investment strategies.
For managers pursuing the US institutional market, in particular qualified retirement plans, another structure that has gained popularity is Collective Investment Trusts (CITs). Though the CIT structure dates back to the 1920’s, the adoption of more fund-like features, such as daily pricing, has made them more attractive. Though functionally similar to mutual funds, qualifying CITs are exempt from registration with the Securities and Exchange Commission (SEC). This means that CITs have lower compliance and administrative costs, which makes them attractive to institutional investors. The lower operating costs can also be attractive to managers because it allows for better margins.
Asset managers need to continually find ways to meet their investors’ demands and this can mean using new wrappers to deliver their solutions.
When launching new fund structures, firms need to understand the unique regulatory, operational, and servicing complexities that are involved. This may mean investing in new talent, systems, and developing new operations models. Firms should also work closely with their service providers to understand how the new products will be supported. “These products can be new to many managers, so it’s important that they have the right partners that can help them navigate the challenges,” O’Brien says.
A clear distribution strategy is key when introducing new products because, as Kraft notes, “Managers will not gain assets from advisors and home offices because of these fund structures alone.” Investors need to understand the new products but, equally, managers also have to make sure there is better alignment with distributors as well. This can require a significant effort to educate advisors and the home office on the benefits of the new products.
Given the work associated with launching new fund structures, firms should look to be strategic in their product expansion. “It’s important to complement your traditional funds with other strategies but you can’t be all things to all people,” Rizzo says. “While there is pressure to launch alternative products, firms should continue to focus on their strengths and core competencies.”
Preparing for More Pressure
The pressure on fees will remain constant for asset management and over the next few years will spread from fund manufacturing to distribution. This will be driven by market pressure as investors look for cheaper ways to access fund products, through channels like robo-advisors. Regulators will also play a part in the increasing pressure, as O’Brien notes, “Both ESMA and the SEC have indicated that they are going to look at how fund products are distributed to investors.” Asset managers should be looking to get ahead of this trend and think about how to leverage technology to reach investors directly. This could cut some of their distribution costs and enhance the customer experience. In a world where asset management is increasingly commoditized, the customer experience will become a key differentiator for firms.
Despite the challenges, the asset management industry is going to continue to grow and evolve. However, this doesn’t mean the struggle isn’t real for individual firms. While new fee models, securities lending, and alternative fund structures may provide some tactical relief, asset managers need to have a clear long-term strategy to deal with the changing landscape.