I am known to occasionally throw zingers at my colleagues from time to time. One recent example was my proclamation to a rather bright yet puzzled actuary that the theory of constant energy applies to investment management. The theory of constant energy is quite simple: energy cannot be created or destroyed—it is simply moved around.
Applying this to investment management, the zero-sum arithmetic of active management states that all investors form the market, so any investors performing above the market must be offset by investors performing below the market. As a result, all active management sums to the market for effectively a net-zero return versus the market, on a gross-of-fees basis. This concept is not terribly perplexing to investment professionals as the concept of the zero-sum arithmetic of active management is fairly well publicized although maybe not be entirely accepted.
While this concept is not very encouraging news for fans of active management—and it should make investors very cautious about their manager structure and the importance of developing sound criteria for manager search and selection—I am more interested in how our attitude toward fees fits into this concept.
As we have seen over the past several years, many investors have chosen to passively invest their fixed income and U.S. equity assets at lower fees, and we have seen an increase in the use of alternatives that typically comes with higher investment management fees. This generally fits with the concept above and forms what I call the theory of constant investment management fees. So far, it would seem that the lower-cost passive strategies have been offset by the higher-cost alternative strategies—but without impacting the fees charged by the remaining traditional active managers. Total investment management fees charged, I propose, have been fairly consistent in Canada, although fees paid by some of the larger plans have actually increased with increased commitments to alternatives.
Will this trend continue such that the remaining active managers slowly but surely have their fees chipped away at? It is probably some time off as all things in the institutional world move slowly, but if interest rates remain low and elevated economic and return volatility continues, it is likely that defined benefit (DB) plan sponsors will have no choice but to reduce costs where possible. This is a looming and striking reality for many plan sponsors and investment managers. As we have seen with the increasing use of alternatives, managers are quite good at reinventing themselves. In the absence of being rich and being able to come up with the money to improve funding status, sponsors will need to reduce costs where possible while undertaking investment strategies that will take many years to realize success.
In part, this is due to the collective shift already under way toward capital accumulation plans and consumerism (the movement from employer-provided to employer-employee sharing such that employees are consumers of employee benefits and other programs). The more immediate and significant DB challenges are associated with trying to solve an impossible puzzle that requires the optimization of three often-conflicting objectives:
1. maximize security of benefits;
2. minimize short-term volatility; and
3. maximize long-term returns.
As a result, investors who cannot afford or take the time to implement specialized phased-in investment strategies to improve funding will look to reduce costs where possible. This is effectively the first tenet of the millionaire-next-door philosophy—live well below your means. Sponsors under cost pressure can lower costs in many ways, including direct costs such as the benefit formula and investment management fees. There are also implicit costs such as the complexity of the plan design(s) and manager structure. Direct costs are easier to quantify than implicit costs, and any savings will go straight to the plan balance sheet, so investment management fees are a prime candidate for examination over the less attractive and arduous task of evaluating the DB formula.
To date, plan sponsors have not been really cost-sensitive. It appears that this is likely to change.
Peter C. Arnold is the national practice leader, investment and CAP consulting, with Buck Consultants.