The New Jersey Division of Investment’s decision at the close of May to halve the state’s pension funds’ hedge fund allocation to 3% from 6% to save on asset management fees raised nary an eyebrow, viewed by the industry as just business as usual—just another fund in a long and growing list of institutional asset owners moving to reduce asset management costs. Since the financial crisis, cost management, in general, and investment costs in particular, have climbed in importance as a fiduciary imperative at institutional funds.
This focus is forcing asset managers’ fees down. A recent industry report suggests that room for fee negotiation is now less dependent than ever on mandate size and region. Some observers have questioned if this new “fee obsession” will lead to lower-quality asset management services and to the insolvency of asset managers? (IA, 9/3/2018). Others say that market dynamics are as they should be and ultimately these forces will work to the greater good of the industry.
“There is definitely widespread downward pressure on fees and focus on fees for actively managed products, particularly since active equity managers have not, as a group, kept pace with benchmark performance for several years and plan sponsors have migrated more heavily to passively managed products as a result,” said Eileen Neill, a managing director and senior consultant with Verus, summarizing how the current asset-management fee environment has developed.
“Almost all investors have embraced passive asset management more broadly and that has driven fee compression,” Peter Madsen, CIO of the approximately $2.5 billion Utah School & Institutional Trust Funds Office, concurred. “But, also, institutional investors have gone beyond adopting some passive allocations and have done more work to negotiate fees down,” he added.
The New Jersey state pension system is said to have paid $95.5 million in management fees, performance fees and expenses to hedge fund managers in fiscal 2018, raising the ire of labor unions whose members participate in the fund. It was reported that the unions then pushed for the change in HF investments.
Examples of other state pensions moving to lower asset management fees are numerous and include: The $55.7 billion Pennsylvania Public School Employees’ Retirement System (PSERS) last summer embarked on a plan to reduce its investment management fees by about $2.5 billion through 2050. The fund wants to increase its internal management capabilities and renegotiate fees with managers. Similarly, last fall the $110 billion State of Wisconsin Investment Board (SWIB) in an initiative to reduce costs, created 17 new investment support staff positions to boost its internal asset management infrastructure.
A Pew Report
According to a September 2018 report from the Pew Charitable Trusts, asset management fees paid by state pension funds that responded to a survey increased by approximately 30% (as a percentage of AUM) over the past decade but that they vary widely across funds. Based on 2016 data–the most recent year for which these figures are available, according to Pew–the reported said that fees ranged for 2.23% for Arizona’s Public Safety Personnel Retirement System to 0.04% for the Georgia Teachers’ Retirement System. The report, titled State Public Pension Funds’ Investment Practices and Performance: 2016 Data Update, said that increased reliance on alternative investments coincides with a substantial increase in fees, and that state pension funds reported investment fees equal to approximately 0.33% of asset in 2016, and noted that although the increase may seem small, it equates to more than $2 billion in total annual investment fees for the 73 plans included.
A Buyer’s Market?
The gap between asset managers’ stated and negotiated fees, in which institutions pay actual fees that are lower than managers’ stated fee rates, is one area that illustrates the “buyer’s market” in which asset owners wield increasingly strong pricing power.
“What the data shows us is that even at the small commitment levels there is still negotiating powers, and a willingness by the managers to do so.”
According to a recent report from data research firm eVestment that covers institutional equity and fixed-income asset management fees as of June 2018, for the All U.S. large-cap equity class, the gap between stated and negotiated fees is 15 basis points for mandates up to $100 million, and 14 basis points for mandates in excess of $250 million. For All U.S. mid-cap equity, the gap is 7 basis points for mandates up to $100 million and 15 basis points for accounts in excess of $250 million. For All U.S. small-cap equity the differential is 10 basis points for accounts up to $100 million and 24 basis points for mandates exceeding $250 million.
The report, published in late April and titled The State of Institutional Separate Account Fees, covers 8,000 separate accounts in eVestment’s database. The widest gaps are found within small-cap mandates. The difference between stated and negotiated fees for U.S. small-cap growth mandates larger than $250 million is 30 basis points, where stated fees average 77 basis points and negotiated fees average 47 basis points, the report indicates.
On the fixed-income side, the report indicates that the gap between stated and negotiated fees for the U.S. core fixed-income class is 3 basis points for mandates up to $100 million; 7 basis points for mandates in excess of $250 million; For U.S. core-plus fixed income the gap was 4 basis points and 9 basis points; for U.S. floating-bank-rate loan-fixed income the gap is flat and 10 basis points; and for U.S. high-yield fixed income that gap is 9 basis points and 7 basis points.
"Truly skillful managers that manage their businesses well will survive and so they should. My guess that firms that may need to close their doors in this environment are those that have had performance challenges and/or that did not effectively manage their businesses well.”
One take away from the differentials between the stated and negotiated fees in the report is that it implies that there is flexibility on fee negotiation by size and region—“It is not necessarily that the small mandate equals no negotiating leverage,” said Peter Laurelli, global head of research at eVestment, “What the data shows us is that even at the small commitment levels there is still negotiating power, and a willingness by the managers to do so.”
Asked how he views the downward pressure on fees the industry has witnessed in recent years, Madsen said, “I think it is a positive, as there should be greater delineation of talent, resources, strategies, etc. At one point, just being a hedge fund, you could charge two and twenty 20. That has changed a lot and there are a myriad of fee schedules [sic]. Similarly, in traditional active [management] there has been a growing effort to separate alpha from beta and pay separately for each. These seem like healthy trends to me relative to where the industry was when I started 20 years ago.”
“From a near-term revenue perspective, it’s a negative event,” according to Laurelli. “This is a source of revenue for the institutional investment community. Lower revenue is not a positive thing. However, I think it is a natural thing. With natural forces playing on markets that is ultimately a positive thing that will result in all around better matching of expectations and value. And if that is the end result, then ultimately that’s a positive for the industry. In the meantime, fee pressure and lower revenue is difficult.”
“This is a positive trend,” Neill asserted. “Active managers are fiduciaries and must focus their resources and personnel on the delivery of performance for their clients. Lower fees have the positive effect of causing firms to trim fat and reduce costs such as the move from high rent to lower rent areas (e.g., AllianceBernstein’s move from New York to Nashville and Dimensional Fund Advisors from Santa Monica to Austin, Tex.) and to be more mindful of how they spend their client’s fees. Truly skillful managers that manage their businesses well will survive and so they should. My guess is that firms that may need to close their doors in this environment are those that have had performance challenges and/or that did not effectively manage their businesses well.”