The Man Who Could Eat Half the Profit in Fund Management
(Bloomberg Gadfly) -- In June 2016, he laid bare the asset management industry's dirty little secrets: actively managed products haven't performed better than their benchmarks; firms have grown too big as they focus on gathering assets; and fees have been structured to benefit shareholders rather than clients. That message proved unpalatable. Within a year, Peter Kraus was out as chief executive officer of AllianceBernstein Holding LP.
But at least one of the remedies he championed at the $480 billion fund manager is catching on. Shortly before Kraus's departure, his firm won approval to introduce performance-based fees in the U.S., and may do the same in Europe. Fidelity International has introduced what it calls a fulcrum fee model, and Japan's $1.5 trillion Government Pension Investment Fund has said external firms will get the same as their passive peers unless they outperform their benchmarks.
If pay-for-alpha becomes the industry norm, some active managers could see more than half of their profits disappear, according to Morgan Stanley analysts.
The other way of looking at it is that customers would save a ton of money they currently pay in fees. Active managers who fail to beat their benchmarks would suffer, as would index-huggers. That, to me, seems to be a desirable outcome. I caught up with Kraus by telephone from New York earlier this month. Here's a lightly edited transcript of our discussion:
MARK GILBERT: You said individual funds had got too big to perform. If anything, that situation seems to be getting worse rather than better?
PETER KRAUS: The industry hasn't restructured itself since I made that comment, so if anything active managers have continued to struggle with their performance. Part of the problem is that the whole industry is motivated by growing assets. It's driven by shareholders who want revenues to grow, and the way you get revenues to grow in an industry that's paid whether or not it performs is to grow the assets. As assets grow, it becomes more challenging to perform.
MG: The recent move by Japan's GPIF identified exactly that problem; it basically accused its external managers of being asset gatherers. Performance fees seem like an idea whose time has come?
PK: I hope so. I was quite outspoken on this point a few years ago. I did speak to my then colleagues, other CEOs in the industry, and said `I think we have to change.' I recognized that that meant adopting a revenue model that would be challenging for their shareholders. But the issue is that the active business has lost the trust of its client base, and the only way you’re going to recapture the trust of your clients is to restructure the business arrangement between the two of you. To me, the right restructuring was to ask the client to pay for performance, but not ask the client to pay more than the ETF fee or the passive fee if you weren’t performing.
MG: When you were advocating this to folk within AllianceBernstein and to other CEOS, what was the reaction?
PK: Other CEOS are smart people. They were thoughtful about it. But they're in a box. If they were to change their revenue model dramatically, that would affect their shareholders and potentially their share price, the motivations and infrastructure of their own companies.
MG: What about the argument against performance fees, that they encourage riskier investments by managers trying to seek the upside and chasing those higher performance fees?
PK: If the manager is faced with a performance based fee with a cap, and the performance based fee resets every year, why would the manager take excessive risk given that if they outperformed dramatically they wouldn't actually get paid for it because they would have hit the cap? That's not rational. Everybody who asks that question believes that the management team overseeing the risk of the manager does exactly nothing -- which isn't true. Of course they have risk limits, of course they have risk parameters, of course they have an understanding with the manager that if they break those risk parameters, there's action that would be taken.
MG: So the rational behavior and the tracking error management will curtail any risk?
PK: Well, it will curtail irrational and excessive risk; it won't curtail any risk because you want the manager to take risk. Contrast that with the fixed fee structure, where they don’t take any risk because the manager's motivation is to grow assets. When you grow assets, that makes it more difficult to take risk. So you end up looking like a benchmark manager. You're not taking a lot of unconstrained risk because you can't -- you have too much money.
MG: Or indeed they end up being closet trackers, where they charge the higher fees but are just basically following the benchmark?
PK: Very few close their funds, so what happens is the manager has more and more money. Managers aren’t overly confident in 50 stocks. They like 10, maybe 15. When you get more money, you can't keep putting money in those same 10 or 15 names. You have to start buying more, and what you do is you buy more names perhaps that you're not as convinced of, and you start to look a lot more like the index. Over time, those portfolios start to look more like the benchmark. People don't take their money out because you're not underperforming: You're performing at the benchmark, or there's some modest outperformance gross of fees. But you -- the manager -- keep getting paid because you get paid whether you perform or not.
MG: So you're not really aligned with your investors' interests?
PK: The business has to be restructured so we can regain the trust of the clients. To do that you have to align the fee structure with the client. I think the market will force the industry to change. If you're a manager that’s running your business on performance, you're going to cap your capacity, you're going to say to clients: `My business has as much money as I want for me to perform at the level I want to perform at, because you're going to pay me if I perform.' That probably says that the amount of money that's currently managed by active mangers dwindles. It shifts to mangers who are actually getting paid by performance, and the managers who can't perform go out of business -- that’s the Darwinian aspect -- and the balance of that money goes to passive. It has to go somewhere.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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