(Bloomberg) -- The asset management industry is in a funk. The popularity of low-cost index trackers is crushing fees across the board, while Morgan Stanley reckons a shift to performance-based charges threatens half of the industry's profit. Divyesh Hindocha has an even more radical suggestion: Fund managers should pay their clients for the privilege of managing their money.
Hindocha, a London-based partner at consultancy firm Mercer, wants to turn active managers into principals, rather than agents. If they really can outperform a given benchmark given a long enough time horizon, they should be willing to offer clients a fixed return over the benchmark—the fee for managing the money—in exchange for keeping any further out-performance they generate.
"We keep getting told by managers that their value creation process tends to be longer than the typical horizon of an investor," Hindocha says. "This in turn leads to short-termism. Under the new model their investment time horizon can be aligned to their value creation process."
The willingness of one of the industry’s top consultancy firms to propose such a heretical solution is evidence that active management faces an existential crisis. But it’s also proof that there’s a growing realization that the status quo is untenable; the more willing the industry is to entertain unorthodox ideas, the better its chances of survival. Here's a lightly edited transcript of my Tuesday telephone discussion with Hindocha about his idea.
MARK GILBERT: What's happening in the asset management industry?
DIVYESH HINDOCHA: The role of traditional long-only equity active management is diminishing. There's an increasing allocation of capital to passive management, maybe approaching 30 percent globally. The use of traditional long-only asset capability is declining quite rapidly. The whole industry is in retreat. We know the reasons: It's expensive, it's not delivered sometimes, regulation is increasingly playing a role, and it's quite a difficult thing to get your head around.
MG: How is the kind of customer that the industry needs to serve changing?
DH: Savings systems are changing from defined benefit to defined contribution. When it comes to active management, we've still got offerings that are designed for the consumers of the past—effectively defined benefit schemes and endowments. But there's a new consumer, the individual investor coming directly into the marketplace or through defined contribution schemes. There's a big gap between what the industry is offering and what the individual may want or need.
MG: Talk me through this thought experiment.
DH: Active management has a valuable role to play in society. It helps with the efficient allocation of capital, it should help in holding managements of companies to account, and it provides liquidity and price discovery. All of those are good things. At the individual savings level, if I can add a little bit of additional return on top of what I might get by just investing in an ETF, that's going to be valuable over a 20- or 30- or 40-year time horizon.
But we've got to completely change the way we think about active management. The defined benefit investor can still say "I know how to identify managers, I can put the managers together, I can negotiate fees. Having done all that, after five years I reckon I can extract 120 basis points of extra return after paying fees. Because I'm clever enough." Those folks can continue playing that game.
The needs of the individual investor are different. The active manager needs to say "give us your 100 pounds. We're going to give you the market return plus 30 basis points, guaranteed," which is small but valuable. We as the active management community go away and if we manage to extract some alpha, good for us; after paying you your 30 basis points, we'll keep everything. As far as the saver is concerned, they don't care what the manager does. As long they get the market return plus 30 basis points, they're much better off than the alternative, which is probably an ETF charging them, maybe, 50 basis points. So, net, they're better off by 80 basis points, which is hugely valuable over a 20 or 30-year time horizon.
We're going to be long-term greedy because we think we can make money by active management, and we'll give you a little bit and the rest we'll keep. We know there will be periods in which we will struggle. But that's OK, we'll sort that out. That's not your problem, but over time, because we think we're good at this, we should make a successful business out of this.
MG: What happens if, over the five-year period, the active manager under-performs the benchmark?
DH: The active manager believes that over time they can outperform the market by 100 or 150 basis points. That's their model. There will be periods when they under-perform, but over time they ought to make money. Why would a manager do this? Take a manager using the current model, charging a fee for what they do. The manager says we continue to run, say, 90 percent of our business on the old model where we are collecting fees and handing over alpha, and 10 percent of our business is based on this new model. So the fees coming in from the 90 percent will help fund the short periods of under-performance the manager might experience in the 10 percent. Long-term, we're making more money because we know that instead of giving up all of our alpha, we'll only be giving up a third, maybe a quarter—and the rest we'll keep.
MG: Have you pitched this to Mercer clients? How open are they to the idea?
DH: First, we want to try and get this idea out and debated. There are a couple of conversations taking place with our clients asking how this would potentially work for them. The second step would be to try and find, say, half a dozen managers prepared to put in half a billion or a billion each, for example, and run a small experiment to see how this might work. On the client side, I think this can fly very quickly; the difficult part is finding managers who want to play.
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