One Manager’s Radical Idea: Zero Management Fees

“The problem for active management is not high fees,” says a recent article in Institutional Investor, “but rather that they charge investors during inevitable periods of underperformance.”

This according to new research from active manager Westwood that focused on designing fees around the probability of investors earning risk-adjusted excess returns. The firm’s head of product management, Philip DeSantis, recently explained in an interview that under the traditional model, “You’re paying a fixed fee for an uncertain outcome. Beta drives a large portion of the total return for any long-only mandate, even though the active manager gets paid on the entire bucket.”

Westwood’s proposal suggests charging zero percent for managing capital and 30 percent for outperformance—a 0-and-30 model. Paying only for alpha, the firm contends, would “help investors grapple with volatility. In bad years, investors do not pay any fees. Active managers need to give investors a better probably of winning,” according to DeSantis.

The effort, DeSantis explained, is also intended to fight the movement to passive investing: “If an active manager charges a low based fee combined with a performance fee, there’s little incentive for investors to opt for passive. That’s because the active strategy is only charging for the alpha it creates in the years that it is actually produced.”

According to Westwood’s calculations, with a 0-and-30 model, investors would pay 16 percent of alpha for a fund that earned 6 percent. DeSantis says, “When you underperform and then look at fees, that’s where the angst happens. This is a mathematical myth of the industry that causes active management a lot of pain.” His proposal, he says, offers a way forward for a business that is becoming increasingly commoditized.