Active managers need to start delivering better value for money to investors as they reach a point where fees can no longer be cut in their battle with passive fund houses, according to Orbis Investments’ Dan Brocklebank. 
Brocklebank, head of Orbis’ UK operations (pictured), said investors focused on net-of-fee returns are increasingly looking to find ‘value for money’ from active managers particularly when cheaper passive solutions are available.
“If you go and buy your groceries or you go and buy a new car intuitively you think about value for money,” he explained.
“You might buy a BMW even though it’s not the cheapest car because you value the availability to accelerate ridiculous speeds from traffic lights. Likewise, you might want to have an organic tomato because you think it tastes better.”
Such conversations have never happened in the investment management industry before, said Brocklebank, which has been much more focused on an incentives culture.
In the industry’s case it is driving behaviour not just of portfolio managers but of asset management firms themselves, where the dominant business model has been fees as a percentage of assets under management.
This well-established model, however, is now being challenged by a mega-trend of low-cost passive strategies.
Active and passive as proportion total UK AUM (2008-2017)
Source: Investment Association
“If you are the owner of an asset management business [you have to ask] ‘can I reduce my percentage?’,” he said.
“I would say that’s pretty hard to do as they tend to be quite sticky but if I want to increase the profits of my business – and this is not unreasonable in a capitalist society – you have to increase revenue.”
The only way that this can be done realistically, said Brocklebank, is to increase assets under management.
Indeed, the Financial Conduct Authority’s interim asset management study in 2016 showed that there profit was strongly correlated assets under management, as the below chart illustrates.
“Larger firms’ revenue increases as assets under management increases, consistent with the ad valorem pricing model (charges are a per cent of AUM),” the regulator noted.
Profit plotted against AUM
Source: FCA
There are a number of ways that asset managers can grow assets and several signs that investors can look out for. But, more importantly, said Brocklebank, asset managers need to avoid periods of sharp underperformance, which could prompt investors to redeem.
“There are no shortage of stories where that is happening today but it’s always been the case that people tend only to redeem when performance is notably negative,” he said.
As such investors should beware of fund managers that might try to run the portfolio as close to their benchmark as possible to prevent significant underperformance.
Another sign to keep an eye out for is the launch of new funds based on asset classes or trends that are popular, which may not always be in investors’ best interests.
“What we’re finding is that where ideas tend to be popular in the mainstream press, that popularity is reflected in the prices of the underlying investment,” said the Orbis Investments’ Brocklebank.
“It might be beneficial for you in terms of raising assets under management but what’s popular is rarely a good investment opportunity.”
A third sign that asset managers might be trying to increase fees is by upping their marketing game to grow assets, which can also be a challenge.
“The problem with that will tell you that with any investments strategy or portfolio at some point time you will hit the threshold at which performance starts to become a challenge,” he explained.
However, Brocklebank said it is a conflict of interest between clients and managers for whom there will always be a temptation for managers to grow their funds.
There are ways of aligning clients and managers on the question of fees and that is by focusing on value for money.
Where the rise of passive strategies has changed asset manager behaviour is by offering investors access to markets for relatively no cost.
“I don’t think the solution for active managers is that they should cut fees,” he said. “If you cut fees unless you can reduce expenses by the same amount to keep profits the same you have to replace that revenue by attracting more clients and to do that your fund has got to get bigger.”
Instead, there needs to be a reappraisal of the existing fee structure and the adoption of something that is fairer for both the manager and client.
“Clients pay those fees regardless of performance and people have joked over the years that the set-up is equivalent from a manager’s perspective of ‘heads we win, tails you lose’,” Brocklebank added.
“But what if we could change that proposition from to ‘we the manager only win if you the client win’? I think most people would say ‘actually I’ll sign on to that because you might create a lot of value for me in which case the fees should be higher’.”
However, it is difficult for clients to know how much value is going to be added when they first invest.
“You can’t know with an investment manager what the value is before you invest with them,” he said. “If you go to a BMW car showroom you’re going to know how fast that car goes or how cool you feel in it or how much you like it.
“But if you invest with a manager you have no idea what he value-add is going to be. If you set your fees based on how much you invest with them, you end up paying that fee regardless.”
As such, the Orbis UK head said that there needs to be a transfer of risk from the clients to the fund manager in the form of a performance fee.
While the fees have been controversial with investors, old 2/20 models – 2 per cent annual charge and 20 per cent outperformance fee – are becoming rarer.
Brocklebank said Orbis’ method of no up-front charges and a 50 per cent outperformance fee aligns it better with client interests.
The fee is paid into a reserve in periods of outperformance which the manager draws upon when there is sufficient value. However, when there is underperformance it rebates fee money to investors at the same rate.
Performance of fund vs sector & benchmark in 2018
Source: Investment Association
Last year, the four FE Crown-rated £66.3m Orbis Global Equity fund made a 12.5 per cent loss as the MSCI World benchmark fell by 3.04 per cent. As such the fund – which has an ongoing charges figure (OCF) of 0 per cent –rebated investors 1.9 per cent in 2018.