By Jagdeep Bachher and Ashby Monk
Public pensions and university endowments often rely on external asset managers to produce investment returns that meet their long-term social objectives, be it paying an old-age pension or funding a university. The bigger the gain, the more secure the pensions for beneficiaries and the more money available to educators.
With this simple formula in mind, many sponsors of pensions and endowments, such as governments and universities, have pushed their funds to seek out more risk in the pursuit of higher returns. What many Americans did not fully understand about this decision, however, was that the higher investment performance delivered to pensions and endowments came with much higher compensation for Wall Street.
Today, the easiest path to becoming a billionaire in America is not to start a technology company but to start an investment business. There is some serious irony that in trying to bolster the solvency of our most important social institutions, we have perhaps unwittingly created more billionaires on Wall Street than in any other industry in America. We did this without telling the public, often our stakeholders.
Most people did not grasp the sheer scale of compensation paid to external asset managers by public pensions or endowments because the compensation data was usually buried in fund footnotes or hidden in net asset value calculations. We have heard many explanations for why this data is so closely guarded, but what seems most likely is that these funds were afraid that the public — armed with true fee and cost information — would prevent them from investing in the high-cost asset classes and managers that were delivering the strong returns they targeted. The baby, they feared, would go out with the bathwater.
Now it’s becoming more difficult to hide these costs. They are too big. And there are new reporting regimes emerging in places like California that are forcing funds to disclose the true nature of this compensation. We’ve seen funds such as California Public Employees’ Retirement System own up to past failures monitoring fees and begin work to remedy their processes. And the Securities and Exchange Commission has recently investigated fees and costs of alternative managers, finding a startling amount of overcharging. Newspapers around the world are now putting fee and cost numbers on their front pages for all to see.
In short, the public is starting to understand the transfer of wealth from our pensions and endowments to private asset managers, and the reactions are increasingly fierce.
But before the public overwhelms our industry with new and more draconian demands to ‘fix’ our fee problem, we wanted to offer our peers some convincing reasons to be more proactive about fee transparency, which in turn, we hope, will prevent the response from snowballing out of control.
At the University of California, we recognized a fee problem in our portfolio about three years ago and sought to put our organization on a more equitable path with our external managers and partners. We don’t manage our assets just to minimize fees; we aggressively minimize our fees to maximize returns. This means that we may pay high fees when they are earned, but we aggressively police our managers to ensure that the fees are, in fact, earned. To do this, we’ve created a culture that embeds fee transparency and understanding of costs into every decision we make. Just as we do annual reviews of portfolio construction, asset allocation and risk exposures, we now do an annual review of fees and costs. This is one of our core governance items, and we think of this fee review as our spring-cleaning.
More than just cleaning, however, we’ve identified four key benefits from our focus on fees that some of our peers might not anticipate:
1) Mutually-Assured Success. After studying our portfolio — past and present — we learned that our managers did their best when their personal economic interests were perfectly aligned with our own economic interests. We also learned that when this sort of alignment was murky, or allowing managers to get rich from fees without sharing in the pain of losses, the investment performance, on a risk-adjusted relative basis, worsened. As you can imagine, we now spend a lot of time trying to align our interests to those of our managers. One way to do this is to ask our managers to invest a meaningful portion of their net worth alongside us. And we do ask them to do that. But we have also found that we can gauge alignment of interests through a careful and almost forensic analysis of the fees we’ve agreed to pay and the incentives those fees create.
2) Risk-Free Returns: Academic theory tells us that there is no return without risk. But we think we’ve actually found a risk-free source of return. Today, thanks to our growing expertise in fee structures, we often achieve an identical exposure — i.e., same asset managers and investment products — at lower cost. We think the fee savings we capture counts as risk-free-returns, and we’ve taken to calling it “non-investment alpha.” What’s more, we’ve also found it’s far less rare than we thought it would be, as fees and costs used to be managed as almost an afterthought to an investment, which means they were not properly optimized. By working with third parties to help quantify complex fee structures and implement fee savings, we think we might actually be getting something for nothing. (Either that or we’re stopping our asset managers from getting something for nothing, which we admit is perhaps more likely.)
3) Good Governance: The responsibility of pension or endowment boards, management teams and senior investment professionals is often as much about building professional and effective investment organizations as it is actually picking things to invest in. But in order to properly resource an investment organization, one has to first assess the true cost of producing a target return. It doesn’t matter whether the returns are produced internally or externally. Once we have that cost, we can then decide whether it’s best to produce the return internally or buy it through service providers. Without the full fee and cost information, all these decisions are sub-optimal. We often see the people who oversee funds pushing incredibly hard to keep internal resourcing to a bare minimum. It may appear in annual reporting that they’re running a low-cost organization, but the tradeoff is often that the pension is all the more reliant on external managers, who squeeze a better deal out of negotiations and then hide that compensation in opaque performance-based fee structures. You would never buy a car based only on the possible speed it can get you from point A to B, and the same is true of asset managers.
4) The Long View: Our office has been investing for 80 years and will be investing for another 80 or more. This means the time horizon over which we measure returns should be long. It also means we don’t want to pay for short-term performance, especially if it erodes long-term performance. We think some fee structures overly reward short-term profits at the expense of long-term value creation. How many PhDs in chemistry or physics — our own students at the University of California — have been sucked into hedge funds to build black boxes that arbitrage a minor mispricing of securities over a short horizon? Many. Is that going to drive economic growth 60 years from now? Probably not.
We feel an obligation to consider the negative consequences that some fee structures create for society. At the University of California, we have seen our tweaks to fee structures extend the horizon over which our managers consider investments. And we believe the more we can direct our managers to consider long-term value creation and avoid short-term rent seeking, the better off we — as an investment office, country and planet — will be in 80 years.
Today, pensions, endowments, and foundations are the ultimate owners of capital in America, and the principals in our capitalist economy. We know we have a core objective to generate high returns, but we think doing this sustainably means that we accept our role in the economy and start to properly discipline our agents and ensure they act on our behalf. Unfortunately, the agents we work with often try to turn the tables on us. They use claims of scarcity and secrecy to try to discipline us, dictating the terms upon which we can join a partnership. We think this is a perversion of the classic principal-agent dynamic that underpins capitalism, and it harms our economic system.
By minimizing the importance of fees and costs and keeping them a secret from the public, we’ve allowed our pensions and endowments to go under-resourced and allowed our asset managers to enjoy an incredible advantage at the negotiating table. We need to start viewing the entire investment chain — from asset owner to manager — and compensate in a manner that optimizes (as much as possible) for our objectives. And so, while the issue of fees and costs may be uncomfortable, we think it’s critically important to include it as part of a toolkit for good governance.
At the University of California, we are breaking down silos, cutting extra managers and minimizing fee leakage. This is creating many positive effects for our investment organization, and, we hope, some positive results for the world.
*Dr. Jagdeep Bachher is the Chief Investment Officer of the University of California, and Dr. Ashby Monk is a Senior Advisor to the CIO of the University of California and the Executive and Research Director of the Stanford University Global Projects Center.
