INVESTMENT RISK AND PERFORMANCE

by STEFAN WHITWELL, CFA, CIPM

Investment Management Fee Structures

In light of so much sophistication in the investment management business today, it is somewhat surprising how crude and poorly functioning the area of fee structure remains. Yet, fee structure decisions are vital because they direct the behavior and incentives of the investment manager and delineate what that manager needs to do to get paidan area that investment managers and their staff have a keen interest in. In this article, Mr. Whitwell summarizes the chief problems with existing fee structures and presents an innovative and thought-provoking example of an alternative approach in the context of multimanager portfolios. he investment management business today is filled with modern advances, such as sophisticated attribution analysis and the invention of various models for pricing options and custom-made derivatives. So, it is somewhat surprising, given the collective human intellect in the investment management business, just how crude the fee structure side of the business remains. Fee structure decisions are vital because they direct the behavior and incentives of the investment manager and delineate what that manager must do to get paid; and we would all agree that investment managers and their staff have a keen interest in getting paid. As this article demonstrates, there are three empirical dimensions to analyzing fees: (1) nominal returns, (2) risk-adjusted returns (or perhaps only risk), and (3) added value. The first dimension, nominal returns, is simple and well conveyed when investors ask the short but poignant question: Did you make us money or not? This question, however, can sometimes be overlooked in an industry that has nearly perfected the art of making investors feel good about losing: Although our return was 10%, our benchmark, the S&P 500 Index, was down 20%, so actually you did fantastic; we helped you outperform by 1,000 bps! With unfunded liabilities among pension funds growing in real terms, however (we all know that the official and written acknowledgment lags considerably), boards, chief investment officers (CIOs), and portfolio managers are decidedly focusing on absolute

returns. This focus explains, incidentally, the birth and continued growth of the absolute return sector, otherwise known as alternative investments. Needless to say, I do not know many boards, CIOs, or investors who enjoy paying fees when losing capital. At the same time, running any professional investment program has a cost, and boards, CIOs, and investors acknowledge this fact. Balancing these two opposing forces can cause tensions in the context of fee discussions. And so far, the tendency of boards, consultants, and investors has been to attempt to relieve their anxiety surrounding paying fees during loss periods by forcing investment managers to agree to lower fees. Although this approach may seem rational, I regard such fee beatings as poor alternatives to creating incentive structures that reward the behavior investors want and need. Investors want their investment managers to be even more motivated to create the outcome they need. If a client beats down an investment manager on fees, then the most likely consequence will be that over time, in an effort to maximize profit, the manager will start reducing expenses, leading to a lower-quality staff and ultimately to a lower value-added product. These changes reduce innovation and increase risk, and this risk is difficult to measure until it is too late. The multimanager space offers a great illustration of this scenario. A large number of funds of funds (FOFs) have been underperforming their promise (promising alpha and delivering beta). One might expect to see
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managers examining the reasons why and engineering new solutions that might generate more alpha. Instead, we have seen a steady increase in fee beatings and lower value-added arrangements that still pass muster at the board level because the investment management organization offering these services is huge, has a good name, and is presumed to be equally motivated postnew fee. In my view, however, this industry approach is only forcing most FOFs to transform into index funds that provide betaand one could argue that FOF yields will prove to be more correlated the more beta-oriented they become. Having inexpensive alternative-sector index funds (FOFs) is healthy for the industry, and given that most FOF programs have essentially produced beta from the beginning (despite promises of alpha), the fee beatdowns are not irrational. To conclude that multimanager strategies are ipso facto beta vehicles, however, is a huge missed opportunity for pension funds and other investors that need all the alpha and uncorrelated income they can get. Multimanager portfolios, if constructed correctly and with alpha engineering principles in mind, can indeed be reliable sources of high-quality alpha. And we propose that the fees for such vehicles be priced according to the alpha they create, not their presumed beta state. The second dimension of the fee structure puzzle is risk. For years, investment managers have made the case to potential investors that performance fees align investors and managers interests because the fund manager earns a performance fee only if the fund produces new gains. This claim is both true and intentionally misleading because the interests of the investor and fund manager are aligned in only one direction. If the investment loses money, the investor alone suffers the loss of capital. Worse yet, the most common 2/20 fee structure does not take risk into account. To drive this point home, consider the following scenario. Investor A invests in Program A, targeting a 10% annual return in early January. On 1 July, Program A plunges in value, down 20%, but recovers on the back of a sharp late December rally that results in a 10% return for the year. Investor A is not happyrelieved, perhaps. Investor A spent the entire year doubting her decision to invest, concerned about the loss of capital, and worrying about the likelihood of further losses. In contrast, Investor B also earned 10% that year from Program B, which was stable and never had a drawdown greater than 5%.
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From the arbitrary vantage point of the calendar year, both investment programs had the same nominal returns but radically different risk profiles. Should the two investment managers in the scenario just described be paid the same? Did they equally protect capital during the investment time period? No, they did not. Yet, a 2/20 fee structure rewards the managers of Program A and Program B with nearly identical fees.1 What logic can possibly support this system? For consumers, it is rational to pay a higher price for a safer product. This fact is one reason why Mercedes and BMW advertisements often tout the highly engineered safety features of their new models. It is also a fact that during periods of loss, investors do not like paying management fees because those fees further erode their capital base. What if there were a fee structure that allowed fund managers to recoup their cost but that treated the investor more fairly by adjusting the timing so that investment managers were not coming out of pocket during periods of negative returns or underperformance? The third dimension, as Charles D. Ellis, CFA, so articulately points out in his recent article Murder on the Orient Express,2 is added value. The yardstick by which to evaluate added value is the degree to which returns beat their benchmark, with the idea being that it is optimal to pay active managementtype fees for the added value portion of the returns (alpha) and pay index fundtype fee levels for the index returns (beta). In practice, however, asset allocators are guilty of routinely committing two types of costly mistakes. First, they often pay alpha fee levels on both alpha and beta. Second, pension funds are vulnerable to missing out on more value-added investment opportunities because such opportunities, quite rationally, often come with a higher price tag. For that reason, the system weeds them out based on the mistaken logic that the fees are too high (in nominal terms), when in fact, the fees should have been evaluated along all three dimensions. Sidestepping the measurement of added value for a moment, we return to a premise cited earlier in this article: that it is rational to pay more for a higher quality or more desirable earnings stream. This concept is important for investors to keep in mind, and a useful example arises in the context of multimanager programs.

In the case of multimanager programs, the question arises from investors: Why should we pay two layers of fees? This is a logical but half-brained question. The operative question should really be: How much value are you adding? followed by, We will gladly pay you more, the more value you create for us. Consider the New York Philharmonic, which hires a conductor even though it already pays the salaries of more than 100 world-class musicians and support staff. The conductor has unique skills in the art of uniting expert players to create something more powerful than the independent parts. Famous symphonies all clamor to hire the best conductors. Imagine the discord if an orchestras trumpet section were to enter three bars too early; it would be painfully evident to the audience and shatter the musical experience. So, in the multimanager space, much like with orchestras, there is a clear role for the conducting organization, but in deciding how much to pay for the service, an investor must assess the orchestra (inclusive of the conductor) and what it is playing that evening. It is no accident that the tickets to hear Isaac Stern perform the Mendelssohn violin concerto with the New York Philharmonic conducted by Leonard Bernstein cost substantially more than the tickets to attend the same performance played by a local artist with a civic volunteer orchestra. But that is not how the investment industry currently operates: We frequently pass judgment on nominal fees before we even spend one minute assessing the three empirical dimensions of absolute returns, risk, and added value. In logic and statistics, this error is known as a Type II error, and it is one of material consequence in the business of asset management. Assessing added value is crucial, and it can relieve the asset manager from having to predict the future. Instead of bearing the pressure of having to figure out in advance how successful the manager will be and, therefore, agreeing to pay an invariant 2/20, an investor alternatively might agree to pay the manager a variable amount that fluctuates in direct proportion to the value added, subject to a rational ceiling. Likewise, clearly defining added value can also help boards and CIOs decide in advance what their stop loss will be, based on quantitative measures. Such an approach would increase

accountability and also make the decision of cutting a nonperforming manager much easier and more objective for a board or CIO. In this sense, bringing the second and third empirical dimensions of fee analysis into the organizational process can be transformative way beyond the calculation of fees. We all know that at the trade level, stop-loss measures are important to define in advance. How many board-approved investment plans have clear standards that, if not met, result in a manager being fired? Isnt it true that in fact the fire decision is often delayed and debatedand sometimes for political reasons, because one party or another is trying to save face? Consider a CIO recommending that the board hire a certain manager. I would be far more impressed by a CIO who defined terms for measuring manager performance and took corresponding action than by one who didnt have a stop-loss procedure in place. So, how can we tie these three empirical dimensions into one fee structure? Here is one approach that we innovated in the context of an actively managed (daily risk management and dynamic allocation) multimanager portfolio of currency trading subadvisers to determine what is paid to the investment manager for selecting the musicians and being the conductor. The Empirical Solutions fee structure consists of two familiar partsa management fee (MF) and a performance fee (PF)but is unique in five concrete ways:

The account/investment must meet a profitability hurdle for the MF to be paid. The PF explicitly takes risk into account to create actual alignment of interests. The PF has to meet a value-added hurdle before any PF can be paid. The PF percentage varies based on risk-adjusted performance. The formula shifts the timing of fee payments from lower-performance periods to higher-performance periods, when the fees are easier to pay and more deserved.
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In a unique twist, we measure and calculate fees each period but divide the timing of fee payments into two parts. The first part is paid in the current evaluation period, and the second is accrued and paid in the future, subject to performance hurdles being met, in order to better serve the investor (as well as the investment manager because the alternative to a fee-deferral structure is the typical fee beat-down). In measuring efficiency and risk-adjusted returns, the Empirical Solutions fee structure intentionally uses the information ratio (IR). Importantly, the IR measures both upside and downside volatility. Why worry about upside volatility? Isnt making money always good? The answer is specific to the assumption that a lower-risk stream of earnings is of greater value than a highervolatility return streamand specific to multimanager portfolios. One of the biggest risks that multimanager programs face is discontinuous correlation, whereby submanagers unexpectedly start behaving similarly (correlating). When submanagers correlate, bigger swings in performance result. In fact, the only time that unexpectedly large profits can be generated in a multimanager portfolio is when there is systemic correlation. Paradoxically, in this context, upside volatility can signal increased risk and is thus a red flag that must be watched carefully. This critical insight can be deployed in other areas. Following is a fee structure innovated by Empirical Solutions that dynamically accounts for riskadjusted performance as well as all three dimensions discussed earlier: MF calculation: Profitability hurdle: Were the last 12 months profitable?

PF calculation (net of fees for all but the current month): Calculate benchmark information ratio (BMIR)3: Risk-adjusted value-added hurdle: Is portfolio IR > BMIR? If YES, the next step is calculating the PF percentage based on risk-adjusted performance. Risk-adjusted performance hurdle: Is portfolio IR 1.0? If YES, PF percentage = 20% (the maximum). If NO, current-period PF percentage = (Portfolio IR/1.0) 20%; the difference between maximum and actual current period PF, if any, is accrued. If NO, it is eligible for neither payment nor accrued PF. Accrual payment eligibility test: Risk-adjusted performance hurdle: Is the portfolio IR still greater than 1.0 after subtracting the current-month MF and PF? If YES, pay portion of past accruals such that after payment, the portfolio IR remains at least 1.0. The remaining unpaid accruals, if any, stay on the books until the requisite conditions are met, if ever, or until account closure, at which point any accruals are permanently written off (not paid). If NO, the accruals are not eligible for payment this month.

If YES, calculate: 0.083% Account size (think net assets if fully funded; the term account size denotes that in the CTA (commodity trading adviser) sector, partial funding is common, in which case the account size is the correct term and number to use for fee calculations rather than cash or net assets). Pay MF, or what can be, as long as the last 12 months net return is not negative. The unpaid portion is accrued. If NO, accrue the MF, but nothing is paid in the current month.

PEER PERFORMANCE: QUANTITATIVE CONTEXT

For context, over the 78 months ending June 2012, the net BMIR calculation for Empiricals Gulfstream Currency Index averaged 1.5. Thus, the portfolio IR must have exceeded, on average, 1.5 for Empirical to receive PFs, which represents an extremely tough hurdle that justifies what may appear to be higher nominal fees if the performance conditions are met.

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Likewise, during the same period, the annualized information ratio for the NewEdge CTA Index was 0.5 and for the Credit Suisse Dow Jones Hedge Fund Index was 0.7. In short, a high standard must be met for a manager to earn the full fee as described. Lastly, note that although the 2% MF is defined relative to the account size, in the example of a multimanager currency (or CTA) program, the investor receives the benefit of a larger total exposure that is actually being managed because of the inherent leverage of forwards and futures. In the Gulfstream Currency Index, for example, in which the portfolio is volatility adjusted in order to target a net 20% annual return, the Empirical MF has averaged approximately 0.7% (70 bps) over the last 78 months ending June 2012 as a percentage of the total exposure. Likewise, the Bluewater Currency Index, which also volatility adjusts the submanagers in its portfolio, targets an annual return of 10%; for the same period, its MF averaged approximately 1.26% as a percentage of its average total exposure.

used fee structures inadequately consider these important dimensions. Risk, for example, is discussed all the time but rarely when calculating fees. Keep in mind that the fee structure illustrated here is specific to the stated goal of stable and independent returns in the context of a multimanager portfolio. Such a fee structure might not be appropriate for either a singlemanager program or a scenario in which the investment adviser is hired under an explicit mandate to maximize nominal returns. We hope that this article will contribute to future innovation in the two key areas of fee structures and risk-adjusted performance measurement.

NOTES
1. Over the calendar year, Program As manager would have received 95% of the total fees received by Program Bs manageressentially the same compensation for a materially worse job of risk management. 2. Charles D. Ellis, CFA, Murder on the Orient Express: The Mystery of Underperformance, Financial Analysts Journal, vol. 68, no. 4 ( July/August 2012):1319. 3. Calculate the IR for each submanager by taking the after-fee return for the last 12 months (compounded monthly) and dividing it by the annualized standard deviation of the returns the last 12 months. Then, average the submanagers IR. The resulting number is the BMIR. If the conductor does not add value and assembles managers whose return signatures are similar to one another, then the portfolio IR will approximate the BMIR and will be lower than the BMIR after fees.

CONCLUSION
At the heart of fee calculation is the notion of pay for performance. Fee performance has three dimensions: absolute return, risk, and added value. The most widely

Stefan Whitwell, CFA, CIPM, is managing director and head of risk management at Empirical Solutions, LLC.

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