Linking investment management fees with performance.

• Author: Miller, Girard

This article is from One of Kind! A Practical Guide for 21st Century Public Pension Trustees (.Funston Advisory Services LLC, 2017).

Knowing about fees is one thing; doing something about them is quite another. Public pension trustees are increasingly criticized from various corners for the fees they pay to investment managers (which collect enormous sums for the services they provide), and as expected investment returns decline, fees are gobbling up a larger share of pension funds' actual returns on capital.

This article focuses on overseeing how pension plan fees are managed. Oversight includes creating and sticking to a governance structure, and taking a coordinated team approach to minimize fee drag in the portfolio, while aligning the interests of alpha-seeking managers with those of plan beneficiaries. Trustees can use a variety of tools to better oversee investment managers' fees, including a fee policy, a fee workshop, an assessment of how well the interests are aligned, an annual fee report, and a fee management assessment.

At the end of the day, a prudently governed institutional portfolio strives to optimize net (after-fee) risk-adjusted returns. We will focus on the relationships and trade-offs between fee drag and risk-adjusted performance.

In a perfect world, the plan's capital allocation team would pay as little as possible for a given strategy's inherent risk to capital (beta) and align its interests with portfolio managers by tilting compensation to those that produce alpha (risk-adjusted outperformance). As you would expect, the world is not perfect and it's not that easy to quantify all these moving parts, let alone achieve optimal results. But there are some basic principles that will move pension plans closer to an optimizing system that is both transparent and efficient.

FEE POLICY

Developing and formalizing a fee policy provides an advanced and practical application of the fund's investment beliefs. Working with staff and consultants, trustees can discuss and formalize core concepts to drive the management and oversight of investment fees. A written fee policy can address questions such as:

* How should trustees discharge their oversight responsibilities with respect to fees? What kind of fee reporting should trustees receive and how frequently?

* What parts of the portfolio are best suited for passive management? Which are best suited for internal management? What strategies require external managers that seek to outperform a well-understood market benchmark versus an absolute-return or expectational performance target?

* When is a low fixed fee preferable to a performance-based variable fee?

* Who will negotiate the fees, and at what point in the manager selection process? When and how are the results of negotiations reported to trustees? Who will assure compliance with contractual fee terms? How can staff be better trained for fee negotiating, management, and reporting?

* When should fulcrum fees (1) be preferred over flat fees or other performance fee structures?

* What guidelines should be followed in pursuing hard versus soft hurdles? (2) What constraints are placed on performance fees to avoid inducing excessive risk-taking by the manager?

* In most cases, a performance fee or carried interest with a hard hurdle should be preferred over soft hurdles. The latter effectively compensates the manager for beta (risk to the fund's capital) in addition to alpha (skill).

* How is risk considered in the fee structure? Can performance be...