Funds paying over 50% more investment fees than five years ago

Sydney, 28 February 2008 – Superannuation and pension funds around the world are paying on average 50%¹ more in fees² than they were five years ago according to research by Watson Wyatt, the leading global consulting firm. The research found that fees now average around 1.1% compared with around 0.65% in 2002, with the vast majority of these costs being paid in fees to external investment managers and brokers.

Graeme Miller, Head of Investment Consulting at Watson Wyatt Australia, said: “One of the main reasons for this upward cost spiral is investors’ focus on ‘alpha’³, which has increased their appetite for alternative assets. Investors have naturally assumed that they are paying these fees to reward manager skill, but in many cases they are wrong.”

In a research note entitled ‘A fairer deal on fees’, the firm says that many pension funds have been paying ‘alpha’ fees for ‘beta’⁴ performance because the main driver of returns in recent years has been the strength of the markets. This has encouraged investment managers to leverage their portfolios to boost returns, which means that investors are often paying for leveraged beta (market returns multiplied by gearing).

Graeme Miller said: “This is obviously a good deal for investment managers, but not necessarily for their investors. While we strongly believe managers should be fairly compensated, fees are currently too high for the value they deliver—particularly as we enter a lower-return environment. Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in managers’ favour.”

In the note the firm identifies a number of flaws in investment manager fees, including:

• Base fees are currently generally calculated as a percentage of funds under management, which encourages asset gathering and can harm performance
• Annual performance fees can amount to a free option for the manager, as the upside is uncapped but the downside is limited to the base fee
• Fees can also be paid on money waiting in cash to be drawn down for investment
• Many leveraged real estate managers charge fees on the gross exposure rather than committed capital
• Fees charged by fund of funds can use a combination of these flawed approaches and in many instances lack transparency.
  Graeme Miller said: “In the recent past, many trustees have unwittingly paid away the vast majority of their ‘alpha’ in fees, surprisingly even when their fund managers have performed particularly well.”

According to the firm an ideal fee structure should have a low base fee to cover costs and a performance fee which should be calculated over longer periods (typically three to five years), include ‘ghost’ years and have hurdles and high-water marks. In addition, total fees should never be more than 50% of alpha and costs should formally be included in funds’ risk budgets. It also says that fee structures should not be standardised across the industry in view of the increasing diversity of investment strategies and mandates.

Graeme Miller said: “This is a complex area, which doesn’t mean it should be glossed over as too much value has already been allowed to leak away. There are signs of change as we move into a different market environment where many managers will no longer be able to justify their charges without beta to bail them out. In future, active managers that wish to win mandates from superannuation funds must offer them a fairer deal'.

About Watson Wyatt
Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating financial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide co-ordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation, and investment manager selection. Watson Wyatt Investment Consulting provides investment advice to some of the world’s largest pension funds and institutional investors, and has more than 450 associates in Europe, the Americas and Asia.

In Australia, Watson Wyatt is the leading investment consultant to institutional investors, and advises clients with assets in excess of $200 billion. It has offices in Sydney and Melbourne.

Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organisations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,000 associates in 32 countries and is located on the Web at www.watsonwyatt.com.

For more information contact
Sonja Lee
National Marketing Manager
Telephone:+612 9253 3176
sonja.lee@watsonwyatt.com.au

¹There were some methodological differences in the research between 2002 and 2007.
²Fees include investment management fees, brokerage, custodian, performance measurement and consulting fees and other transaction costs.
³‘Alpha” refers to performance in excess of market benchmarks.
⁴‘Beta’ refers to the aggregate level of return earned by markets, and excludes any value added or subtracted by managers through active management.