Are fees incentive enough? The value and importance of co-investment

Investors often, and in good faith, entrust their hard-earned savings to professional fund managers. The fund manager is tasked with managing the investments and for taking this responsibility, fund managers are paid by the investors.

But are fees incentive enough for fund managers to truly act in the best interests of their investors?

According to Paul Cluer, director at Foord Asset Management, the interests of fund managers should be aligned with those of investors and a good, and widely practiced mechanism, to align the interests of the fund manager and investor is to allow the fund manager to command a performance fee. Put simply, fund managers should be rewarded if, as a result of their actions and skill, investors sustainably enjoy superior returns.

“Performance fees allow the manager to share in a percentage of the return on the investment portfolio that exceeds the agreed benchmark return,” explains Cluer. “By the same token, a fund manager should be prepared to allow investors to “claw back” or recoup fees (down to some minimal level) to ensure that a fund manager who underperforms a benchmark similarly feels the pain of loss. Fee rates that decline below the at-benchmark fee rate and high watermark arrangements are common examples.”

However, Cluer feels that the alignment of investor and manager interests through the sole mechanism of performance fees and claw-backs is insufficient. “In an extreme scenario, a fund manager may have all of their personal or corporate wealth invested in one asset class while investor funds are deployed into another. If the investment portfolio were to decline (either as a result of the market’s vagaries or the manager’s poor decisions), investors would suffer the effects of poor returns whilst the manager’s investment returns may be completely different.”

“It is for this reason that the most complete alignment of investor and manager interests is achieved, not only with suitable fee arrangements but also with co-investment.”

Co-investment embraces the notion that the manager’s wealth should be invested similarly to that of the investors. In that way, the manager is exposed to the same risks as those in investor portfolios. Consequently, the manager’s discretion is exercised more keenly and astutely. It is the proverbial concept of “putting your money where your mouth is.”

According to Cluer, Foord has embraced co-investment since the firm’s inception. Notably, the entire amount of the discretionary assets of the staff provident fund is invested in the Foord Balanced Fund unit trust. Companies in the broader Foord group invest their corporate working capital and reserves in the same Foord products as are available to direct investors.

“The vindication of a fund manager’s skill might very well lie in the measure of investment by staff in the firm’s own products. At Foord, almost all staff, including analysts, portfolio managers and administrative personnel, have significant amounts of their own discretionary money co-invested in Foord’s unit trust funds,” says Cluer.

“Co-investment is important, because the higher the co-investment, the more likely the interests of the asset manager and the client will be aligned. What more incentive do managers need to provide performance than to be invested in the funds themselves? Co-investment means that the manager’s own money is on the line, so they will be concerned about the level of risk taken to achieve out-performance, not just the potential returns.”