Daniel Godfrey: LGPS and the cost of active management
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Objectives, capacity constraints and purpose all play a role in deciding what to pay for active management, according to Daniel Godfrey.
How much should you pay for active management?
Not a penny more than you need to.
Perhaps that’s not a helpful answer, but there is no simple answer. To start, let’s assume that you have completed manager diligence and that you believe the active manager has the skills and resources to deliver the objectives.
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There are several factors that need to be considered on a case-by-case basis when assessing whether you’re being asked for a fair price or not.
Objectives
Firstly, you certainly need to have a clear understanding of the objectives that the active manager is promising to deliver.
For example, is the manager aiming to beat an index benchmark? If so, by how much and over what period? Are they trying to limit the downside for their performance against the index, the “tracking error” (which will inevitably limit the upside too)?
Another example, would be where the active manager is not trying to beat an index, but is trying to deliver positive returns after inflation. Do they have a target return objective? Are they trying to limit the downside? Over what period is their promise being made.
Buyers of active management need to be clear that they understand the objectives and the strategy the active manager intends to employ.
Investment managers also need to be clear about measures, timeframes and targets before any contract is signed. Without them, how do you know when and how you should be pleased or disappointed? How can you hold the manager accountable?
Capacity constraints
The second criteria you need to understand is whether the manager describes this particular strategy as being capacity constrained. Are they acknowledging that there may be diseconomies of scale? And, if so, what are they doing about it? And if they are not constraining capacity, do you agree with their analysis?
This all has a bearing on what you should be prepared to pay for active management.
It’s obvious, that you should be prepared to pay more for a higher return. It’s also clear that you should be prepared more for other factors that may be important to you, such as a cap on volatility or downside protection.
But, of course, one of the problems for buyers of active management is that setting an objective is far from guaranteeing that it will be delivered.
That is why performance fees can seem attractive. You only pay the full rate if you achieve your objectives. But on the other hand, do you really expect investment managers to do anything other than showing up every day and doing their best?
And can a performance fee cause perverse outcomes? Could it cause an investment manager to take excessive risks if they are behind their target and have “nothing to lose?”
In the general case, performance fees are unnecessary. The ad valorem nature of investment fees comes with a performance element built-in. The better the performance, the greater the asset base on which fees are levied.
However, in the case of capacity-constrained strategies there may be a stronger competing argument that the manager has the commercial right to optimise their revenues despite voluntarily constraining volumes. In such a case, if the performance fee is structured in such a way as to ensure that, if paid, everyone is happy, then it seems reasonable even if you don’t expect the manager to work any harder.
Purpose
But when you are paying for an active manager, and deciding what to pay, the fundamental consideration is around the very nature of investment. If we assume that the purpose of investment is to create wealth over long periods of time, both for investors, investees and the economy, then we have to ask ourselves to what extent is an active strategy that aims to beat an index benchmark fulfiling that purpose?
The purpose becomes to “beat the market” and an unspoken, although nearly as important, purpose is not to fail by too much. This leads to the incomprehensible outcome of “underweighting” where you pay active managers to buy and hold shares in companies that they think are going to do badly because of the risks of being too far behind the index.
The substantial majority of active, index-benchmark targeted funds fail to beat the market over long periods of time. If beating the market is your objective, you might be better off giving up and buying passive funds or changing your objective.
Given the long-term nature of the needs of individuals, active management would be better focused on long-term, high-conviction, low-turnover, high-engagement that eschew any index comparisons and instead articulate long-term, cumulative, total return targets. With these objectives, skilled active managers will deliver good returns and a healthier impact on the economy and society.
It’s why The People’s Trust is being established with a truly mutual model and with exactly that objective and strategy.
Fair price
So, what should you pay for active investment management? The only sensible answer is a fair price, based on the anticipated outcomes and bearing in mind the criteria and measures that must have clear answers in advance.
Paying for active management that is only trying to beat the index by a small amount is a fool’s game. Look for long-term value for money. And be prepared to be patient.
Daniel Godfrey is a co-founder of the People’s Trust investment fund and a former chief executive of the Investment Association.
