Investors should put more weight on alignment of interests when hiring or firing fund managers, according to a new Mercer report.
While investors necessarily focus on a manager’s investment and operational strength, the study says the “often overlooked” alignment factor provides some important flow-on benefits.
For example, the report says closer alignment motivates fund managers to “generate superior returns” while reducing the need for “intense monitoring” by investors.
“If there is more of a partnership approach, this should result in less switching of fund managers over time,” the Mercer paper says. “Changing managers is typically costly, time-consuming, and subject to transition risk – in short, it is best avoided where possible.”
The ‘Align by design’ report, authored by Mercer NZ principal, David Scobie, defines alignment as “the extent to which a business model directs a fund manager, acting in its own interest, to also act in the best interests of investors”.
The report says investors can assess the degree of manager alignment based on seven factors including co-investment, remuneration, fees, board independence and ownership.
Mercer says while it might be unreasonable to expect a portfolio manager to invest their “life savings” in the products they control, investors should require some “significant co-investment”.
“An absence of meaningful co-investment is particularly open to question when the portfolio manager is well-established in his or her career and hence likely (in most cases) to have significant investable funds,” the paper says.
Investors should also dig into the firm’s remuneration structures, Mercer says, to gain a deeper understanding of manager motivations.
For example, the paper says performance-linked bonus payments released entirely as cash to the portfolio manager could disadvantage investors.
“Most of us would take some comfort if the manager had [a significant proportion of the bonus] locked away for a little while,” Mercer says. “That way, the portfolio manager has no inducement to take risks in the portfolio that may pay-off in the short-term but ‘come home to roost’ at a later date, when the manager may not still be in situ.”
If funds favour performance-based fees (PBFs), linking investment staff bonuses to the “magnitude of such fees earned has merit”, the paper says.
“When it comes to PBFs, the best advice is to explore while at the same time exercising caution,” the Mercer report says.
On the upside, PBFs align fees with performance and potentially create a “self-correction mechanism” keeping managers from exceeding capacity limits.
“That said, the devil is very much in the detail, and thought needs to be applied to such issues as the correct benchmark, high-water marks being in place, a cap on total fee, and so on,” the paper says.
And the longer the period before PBFs kick-in, the more confident investors can be that they’re rewarding manager “skill rather than noise”.
Investors can also encourage alignment by setting explicit investment timeframes, favouring funds with independent board members, and requiring portfolio managers not to engage in personal trading.
“Even if personal trades are cleared through internal [manager] compliance teams, the scope for conflict of interest is hard to eliminate,” the report says. “And why open up the risk when, as a general statement, portfolio managers are fairly well compensated for the ‘day jobs’.”
Somewhat surprisingly, Mercer says staff ownership is not necessarily indicative of strong alignment of interests with investors.
“On the positive side, ownership of the firm by key individuals can help with staff retention, amplify incentives for the business to be a success, and help foster a long-term mindset,” the paper says.
Conversely, owners may focus on the success of the entire business rather than the performance of specific investment products – especially if those products represent a small part of the manager’s overall funds. Furthermore, there can be problems if equity-holding staff members begin to “under-deliver”, the report says.
“Arrangements can be a bit hard to unwind, even though parting company may be the best outcome for the business and the client,” Mercer says.
The paper says alignment may be easier to implement for larger or “prestigious” investors – who hold more sway with managers – or with early-stage managers and investment strategies.
“Notwithstanding some implementation challenges, fund managers have little defence for not being open to discussions aimed at improving mechanisms for strong alignment,” the report says.