In years to come, we may look back on the COVID-19 pandemic and associated lockdowns in many countries as having sown the seeds of new ways of living and doing business. For instance, attitudes towards working remotely, from the perspective of workers and employers, have obviously been subject to upheaval. Many office workers who value the social connectedness that comes from sharing an office space are no doubt looking forward to returning to their workplace as restrictions are lifted gradually. Others have probably been pleasantly surprised at how productive they have been working remotely, and for them, the regular video conferences have proven a good substitute for not seeing colleagues directly. At GFFM – like many other small companies – we are considering whether shared office space for us is redundant in the post-COVID world. For some small companies this is a feasible option, particularly where collaboration amongst workers is strong.
Another area that might look different in a post-COVID world is asset management fees. The key disruption to asset management in recent decades has been the rise of low cost index investing, first in the form of unit trust structures and more recently the development of exchange traded funds (ETFs) which can be traded on market. According to the RBA, Australian ETF assets under management tripled between 2012 and 2017 to be $25 billion at the end of March 2017 and anecdotal evidence suggests that this rapid growth has continued since then.
The advent of these low cost vehicles has put pressure on institutional active management fees, as has the in-sourcing of asset management capability by a small number of large industry super funds. To date, retail active management fees appear to have resisted this pressure, particularly for retail investors seeking exposure to international equity products run from Australia. This might reflect the high profiles and effective branding of a small number of successful Australian owned and managed global funds.
But how much longer can retail active management fees remain high? Prior to founding Amazon.com, Jeff Bezos worked at D.E. Shaw, a quantitative investment management fund. If Mr Bezos had remained in the industry, he could have become rich and comfortable on the base percentage and performance fees charged by hedge funds. Or would Mr Bezos have identified an opportunity to disrupt the industry’s fee structure?
On face value, the persistence of percentage fees in asset management is puzzling given the powerful economies of scale. Once the sunk costs such as IT infrastructure, licensing fees and human capital are incurred, the marginal costs of investing incremental assets is very low. In other words, the costs incurred of managing a billion fund are not materially different from managing a million dollar fund.
In favour of the industry’s existing fee structure, trading costs and brokerage commissions associated with buying and selling stocks are still computed as a percentage fee of value traded. Further, the aggregate income earned from percentage fees generate some social benefits by facilitating price discovery and the efficient allocation of capital.
But the economics of percentage asset management fees lies primarily in the fact that they earn more revenue from investors who have a greater willingness and capacity to pay. This should not be interpreted as a criticism of industry practice; after all, percentage fees in asset management – including index funds and ETFs – are widespread and are widely used in some other industries, notably amongst real estate agents.
At GFFM, we have been giving thought to what an alternative fee structure might look like; one that reflects the economies of scale in asset management and delivers better outcomes for investors. We believe that a hybrid fixed dollar fee and percentage fee represents one pathway forward, particularly for low turnover strategies. To that end, we have introduced a flat fee structure of $499 pa for assets of up to $100,000 and a percentage fee of 0.25% for assets above that amount, with no performance fee. We are not in principle opposed to the risk sharing benefits that arise from performance fees, but are concerned that in some cases, they can give rise to skewed incentives.
Asset managers would understandably be reluctant to move towards a structure that represents even a small shift away from percentage fees because it would be associated with intense price competition and erode profit margins - particularly those earned from large investors. A risk for the industry however, is that its fee structure might be seen as being ripe for disruption by companies with tremendous computer processing power, sophisticated algorithms, access to proprietary information about selling, buying and social trends in the economy, extensive distribution networks and globally recognised brands. Is it just a matter of time before Mr Bezos and the other tech titans come to take away asset managers’ free fee lunch?