Active Equity and Bond Management: Do Managers Really Earn The Fees They Charge?

1. Active Equity and Bond Management: Do Managers Really Earn The Fees They Charge? Presentation to Pension Fund Investment Forum – January 29,2009 Seeking Alignment Yusuf Samad CFA, FSIP Marathon Club Secretary

2. Marathon Club-Background • Formed to stimulate institutional funds to be more long term in their thinking and actions, and to place a greater emphasis on being responsible and active owners. • To promote this approach through practitioner led guidance notes and briefings. • To engage trustees and executives of pension funds in developing forward thinking.

3. Do Active Managers outperform net of fees? • Studies show that the average active manager slightly outperforms the market before expenses and underperforms after expenses. • Yale School of Management** study of all-equity US mutual funds net annualized returns relative to benchmark from 1990-2003 concluded: • The average fund loses to its benchmark index by 0.43% per year. • But managers with more active money relative to the benchmark have higher returns. • Active Share = Fraction of portfolio that is different from the benchmark • ** How Active is Your Fund Manager? A New Measure That Predicts Performance • Martin Cremers and Antti Petajisto, Yale School of Management

4. Co-investment- a strong mechanism for alignment In ancient Rome, when a bridge was completed, the architects and engineers who had initially designed it stood beneath the structure as the first carriages drove over. If the design was faulty, the bridge would collapse and they would be crushed. THAT is an incentive which aligns behaviour with client interest.

5. Management fees cover process and performance • Process • Investment philosophy • Research and analysis • Valuation • Selection • Trading • Portfolio construction, risk control and monitoring • Reporting • Performance

6. Separate payment for process and performance • Ad-valorem fees encourage managers to build their asset bases. • Larger amounts of assets hinder performance. • Performance fees do a better job of aligning client and manager interests encouraging managers to earn higher excess returns. • Encourage clients to be more patient.

7. Marathon performance fee structure • Base fee to cover the manager’s process costs plus profit margin. • Performance related fees designed to earn “normal” ad-valorem fee when target return achieved. • Ratcheting effect - progressively increase performance fee with out-performance of various hurdles. • Cap on total performance fees.

8. Issues with performance fees • Performance fees cause more risk taking - control through guidelines and high water marks. • Myth that managers try harder for clients on performance fees – true but at least it prevents asset gathering. • Hurdle rates. • Time frame for measurement.

9. Feedback from institutional investors • Results of recent bfinance survey of institutional investors. • A high proportion of respondents using performance fees for active equity management. • Priority for investors is to pay lower base fee, then to improve the hurdle rate and finally lower other costs. • Period over which performance fees should be calculated should be 4 to 5 years.

10. Seeking Alignment • Ensure beliefs are aligned between trustees and manager. • Co-investment by manager is a strong mechanism for aligning interest. • Recognise fees paid from investment process and performance. • Marathon Club supports well structured performance fee arrangements.

11. Contacts If you would like more information on the Marathon Club, please visit: www.marathonclub.co.uk For copies of the Guidance Note or further information contact: Roger Emerson, Chairman gonfet@gmail.com Yusuf Samad, Secretary yusuf.samad@aonconsulting.co.uk