Orbis’ Dan Brocklebank (pictured) believes that, with a re-vamp of the old structure, performance fees could actually hold a lot of appeal and in time become something that investors won’t do without – so long as managers bear the burden of underperformance as
well as being rewarded for outperformance.Brocklebank, who is also an equity analyst for Orbis’ recently-launched investment platform Orbis Access, says a surprisingly large portion of his job role involves psychology.
He draws influence from the works of Warren Buffet’s side-kick Charlie Munger, who references the greatest bias that distorts investor’s behaviour as ‘the superpower of incentives.’
Brocklebank said: “It’s one of the biggest biases that distorts human behaviour and at its absolute core tends to be a human impulse towards greed.”
“People typically want more money than less. But when that becomes overwhelming they tend to make irrational decisions. I think [Munger] is spot on. Incentives in any business will determine how people react.”
Given this viewpoint, question marks can be put over the fund industry’s preferred method of getting paid – taking a set fee from assets under management, with no reference to underperformance or outperformance.
Research conducted by Cass Business School, part of City University London, revealed that the most prevalent fee structure, based around an annual management charge (AMC), tends to lead to the best outcome for fund managers but is rarely the best option for clients.
The report, entitled ‘Heads we win, tails you lose’, concluded that fund managers should consider adopting a fee structure that better aligns investors’ and managers’ interests by sharing losses as well as gains.
Brocklebank said: “A good way to know if a manager is really incentivised to get the best performance, rather than just gather assets, is to look at their fee structure. Most funds charge a flat fee which means that gathering assets is at least as powerful a way to raise profits for the manager as getting better performance.”
“A lot of it’s to do with trust. I think when people perhaps think through the factors that matter, they might just be missing a basic psychological observation, which is that incentive structures can be a very powerful indicator of what’s really driving a fund.”
Orbis Access’ funds charge performance fees, which is a heated topic of debate among UK investors. While many people feel cheated by the thought of essentially paying a manager twice to do their job, Orbis has adopted a different approach inspired by the Cass report.
“In the UK, we’re surprised at how much of a bad name performance fees get,” Brocklebank said.
“They seem to be very poorly received in general. But I think the reason for that is that the performances that have been used by the industry have been very poorly designed in the past. A typical performance fee has been borrowed from the hedge fund model.”
Brocklebank is referring to the so-called ‘two-and-twenty’ model, whereby hedge fund managers charge a flat 2 per cent AMC and an additional 20 per cent of any profits earned.
He said: “I think that the incentives behind that are very flawed because the manager will get paid a 2 per cent fee regardless, which doesn’t seem a great place to start, and then the 20 per cent of performance fee they will charge will get paid over to them straight away regardless of whether or not they then go on to underperform.”
“So, the debate about performance fees in my view, is thinking about performance fees in ways that have been structured very poorly in the past.”
Some innovative fee structures have come to market of late. Neil Woodford caught investors’ attention last month when he unveiled a new investment trust that will not levy an AMC, relying solely on a performance fee.
Meanwhile, Orbis is paid if its funds’ performance exceed their applicable benchmark. These fees are calculated on how well the fund does, but they don’t get paid to the manager straight away – if the fund goes on to underperform, the fee reserve is available as a refund.
Brocklebank said: “We thought we had this idea, but it was so far out from what the industry’s practice was. So we actually asked an academic at Cass Business School to have a look at it and just double-check our numbers.”
The resultant study involved the analysis of three different fee models: the industry standard structure of charging a percentage of AUM, the ‘two-and-twenty model and a symmetrical fee structure that takes into account both underperformance and outperformance.
“What they found when they looked at it was that, from an investor’s perspective, in a vast majority of cases, they prefer what we called the symmetrical fee structure and yet nobody in the industry was providing that,” Brocklebank said.
“So then they flipped the analysis round and said ‘well, from a fund manager’s perspective, which is the better fee structure?’ And, lo and behold, it was the fixed structure because it wasn’t geared towards performance and a majority of fund managers were not actually adding any value in any particular year.”
“So they confirmed that there’s this mismatch between what the industry is providing, and what would be in the investor’s best interests.”
Using ‘Monte Carlo’ statistical techniques, the researchers ran thousands of simulations to see how investors in managers with varying degrees of skill fared under the three charging models. While none perfectly aligned managers’ interests with those of the investor, the findings suggested that the current model is not the best for investors.
However, it did conclude that symmetric performance fee structures would be the most attractive for investors. The reason it does not perfectely align manager's interests with their investors is because of the ability to charge a base fee – as the manager still receives some of their fee even if they lose money – but this structure would make underperformance ‘painful’ for the fund manager as well as their clients.
Professor Richard Payne, one of the researchers at Cass, said: “The study identifies a clear incentive mismatch between the best interests of investors and managers. Our results show that the most prevalent fee structure currently in the UK market is generally the best structure for the manager and the worst for the investor.”
Co-researcher professor Andrew Clare added: “It’s about time there was a serious debate about fund management fee structures. Our results show that a symmetric fee structure is, on the whole, in the best interest of investors. How long can an industry ignore the best interests of its customers?”