Investors Should Re-evaluate Fees in the ‘Turbulent Twenties’ 

Long-term fee reduction trend has stalled

In Equities, Fixed Income and Hedge Funds, the broad trend of falling active management fees during the 2010s does not appear to have continued into the ‘turbulent twenties’, first discussed in our recently published Investment Management Fees: Fairness Revisited paper.

In Equities, the broad trend from ‘active’ to ‘passive’ or quasi-passive strategies represented a persistent source of pricing pressure for stock pickers through the 2010s. This tension has lessened in the 2020s. Fixed Income strategies endured fee compression through the low-yield environment of the 2010s. Strong flows to Investment Grade bonds in a higher-for-longer rate climate have somewhat taken the heat off active managers.

Yet in Private Markets, where fee levels had proved more stubborn in the 2010s, recent lower-than-expected fundraising is now supporting a modest migration to more investor-friendly terms. Annual capital raising for the four major illiquid asset classes (Private Equity, Private Credit, Private Real Estate and Infrastructure) rose by more than 400% between 2010 and 2021. Weaker-than-anticipated fundraising in 2022-3—while still high by historic standards—has placed institutional investors in a much stronger position to extract better terms.

Even where official terms appear not to have improved, we have seen considerable real-world pricing adjustment

In Real Estate, themes such as poor performance, falling transaction activity, high levels of redemption and funding challenges have driven improvements in fund terms, producing savings for investors. The trends are more nuanced in other illiquid asset classes such as Private Credit, Infrastructure and Private Equity: even where official terms appear not to have improved, we are seeing considerable real-world pricing adjustment. For example, managers experiencing weaker fundraising are extending first-close discounts with the result being that a higher proportion of their LP group pay lower fees.

Escalating ESG expenses – who foots the bill?

ESG spending—both direct and indirect (via asset managers)—is a theme that requires attention from all investors. According to our recent Investment Management Fees: Fairness Revisited paper, nine in ten asset managers say that their ESG-related costs have “increased materially” over the past three years, citing factors such as expensive climate data and regulatory reporting requirements.

How should the burden of ESG costs be shared between investors of various profiles and managers?

But how should the burden of external asset managers’ ESG costs be shared between investors of various profiles and managers? Perhaps not surprisingly, only half of asset managers believe that strategies involving significant ESG resourcing should be offered at the same price as comparable/equivalent strategies with low ESG resourcing requirements. Yet investors may have a different view. In contrast with their asset manager counterparts, a clear majority of surveyed asset owners expressed a belief that ESG resourcing should not affect a strategy’s overall price. Furthermore, we note less enthusiastic investors expressing concerns about footing the bill for ESG resources that are required by other clients. Moreover, investors are not always clear on what is being covered by the fee and what they’ll need to pay for separately, particularly when it comes to the use of security-level climate data. This mismatch in expectation on ESG expenses can be meaningful in fee negotiations.

Hurdle rate headache – how high?

Another key cost-related theme in the current environment is the case for updating fee structures, particularly hurdle rates. Across Hedge Fund and Private Market sectors, hurdles have largely remained unchanged, even though higher-for-longer rates have increased return expectations in many asset classes, as discussed in Money for Nothing? Hedge Funds Haven’t Budged on Hurdle Rates (Yet). While we have not seen substantial evidence of an overall shift in average pooled fund terms, we do see evidence of Hedge Funds responding to investor pressure and signs of change in Separately Managed Accounts in Private Markets. Cost per unit of performance can be a helpful concept for investors addressing this topic.

Room for reductions

Our recent work indicates that investors can still generate substantial savings, even in asset classes where fee-reduction trends are less prevalent. Interestingly, there is often particularly good scope for generating savings at the low-cost end of portfolios, in strategies such as investment grade fixed income and quasi-passive equities.

Over-payment in low-cost asset classes can be the result of longevity: provider relationships in these areas are typically ‘sticky’ and remain in place for long periods of time.

Over-payment in low-cost asset classes can be the result of longevity: provider relationships in these areas are typically ‘sticky’ and remain in place for long periods of time. It may also be the result of low scrutiny: low-fee strategies may attract less attention and debate relating to costs than their expensive counterparts and may be reassessed less frequently as a result. It can also be challenging for investors to get an accurate understanding of what the appropriate fees should be, especially with semi-passive approaches that may use more complex or bespoke indices (see Passive ESG Investing Needs Careful Attention Amid 'Backlash'). Accurate benchmarking and comparisons, combined with a deeper understanding of the exposures of these assets, can be transformative from a pricing perspective.

Within Equity and Fixed Income, institutional investors are increasingly looking to more sophisticated Transaction Cost Analysis techniques to understand the total cost structure of the strategies, including underlying trading costs. This can highlight surprisingly sub-optimal trading practices (leakage here can be as large as the headline manager fee): data and insight can support effective negotiations.  

Conclusion: focus on fees

Fees—and the broader alignment of interests between asset owners and managers—must be continuously reassessed as macroeconomic conditions shift and analytical tools improve. Investors that remain ahead of the curve on this subject can benefit from favourable themes in some sectors and protect themselves from worsening terms in others.

To read more, download Investment Management Fees: Fairness Revisited.