2nd Week Paying the price

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Buttonwood

Paying the price

Time to reassess how fund managers are rewarded

Jul 29th 2010

FUND managers have been some of the biggest beneficiaries of the financial sector’s growth over the past 30 years. Bankers may routinely earn million-pound bonuses but some hedge-fund and private-equity managers have become billionaires. Seldom has so much been earned by so few.

These riches have been generated despite the ability of investors to take advantage of low-cost exchange-traded funds and index-trackers. Investors have surged off-piste in search of higher returns. In aggregate, however, they will merely end up paying higher fees (typically, a 2% annual fee plus 20% on performance), a phenomenon this column has described as “catch two-and-twenty”.

Two new studies look at the way fund managers operate and suggest improvements in the way they are assessed. In the first report*, Peter Morris, a former banker at Morgan Stanley, is sharply critical of the private-equity industry. It “has been a huge success in terms of size, growth and profitability for its operators and for many intermediaries,” he writes. “It is less clear whether private equity has been a universal boon for its investors or for financial markets generally.”

Mr Morris argues that private-equity managers have charged excessive fees and overstated returns by using misleading measures of their internal rate of return. In addition, he says, the returns they do achieve are due to factors, including high leverage and the overall movement of the stockmarket, for which private-equity managers cannot claim credit.

The leverage point is very important. Pension funds could decide to make a geared bet on equities by borrowing money and investing in the S&P 500 index. But they would understandably regard such a strategy as highly risky. Giving money to private-equity managers, who then use debt to acquire quoted companies, is viewed in an entirely different light but amounts to the same gamble.

Similarly private-equity managers will often realise their investments by refloating firms on the stockmarket. To the extent that the market has risen in the interim, the managers (and their investors) will make a profit. Investors would not dream of paying a performance fee to traditional fund managers merely for matching the market return, yet they cheerfully reward private-equity managers for the same feat.

Of course, the private-equity groups claim that they have stockpicking and management skills, selecting the right companies to buy and then transforming them by judicious cost-cutting and investment. But it is those skills for which they should be afforded performance fees, Mr Morris argues, and those alone.

The second study** looks at traditional fund managers, those who run mutual funds and stockmarket portfolios on behalf of pension funds. A lot of sophisticated-sounding benchmarks have been devised to measure their performance, such as the Sharpe ratio, which compares the volatility of a portfolio with its excess return (over the risk-free rate).

But the authors propose a very simple measure, first suggested by Paul Myners, a minister in Britain’s last Labour government. The idea could be dubbed the “inertia benchmark”. Clients would look at the performance of the manager’s portfolio over the past year and compare it with the return that would have been achieved had he done nothing at all.

This approach has two advantages. First, it directly measures the impact of a manager’s decisions: did his buying and selling add value to the portfolio, or subtract from it? Second, it discourages the excessive trading or churning of portfolios, an activity that incurs high transaction costs and diminishes the client’s return.

The authors conducted an experiment in which 12 groups of students were asked to pick 23 stocks from various national indices. The groups were allowed to change their portfolios over a three-year period. The “inertia” funds (those originally selected) performed better in two out of three cases, with an average outperformance of almost four percentage points.

Who knows how many professionals would pass this test? Clients would face a lot of opposition if they tried to restrict managers’ fees. But after a decade of dismal returns it is time for them to act. They cannot control the level of future returns but they can do something about costs.

* “Private Equity, Public Loss?”, by Peter Morris, Centre for the Study of Financial Innovation, July 2010. 

** “Economists’ Hubris—The Case of Equity Asset Management”, by Shahin Shojai of Capco, George Feiger of Contango Capital Advisors and Rajesh Kumar of the Institute of Management Technology, April 2010.

Economist.com/blogs/buttonwood

Finance and Economics