The financial alchemists at ERI Scientific Beta are offering an innovative way to charge management fees: you only pay when their product delivers on its promise.
The lure of so-called smart beta funds has always been the promise, whether stated explicitly or merely implied, that the people running them have a secret formula for beating the market. There are no guarantees of course, but the way active funds are marketed and promoted make it clear that it’s all about superior, market-beating performance.
But the pitch has a glitch. Superior performance ain’t free. There is no such thing as a not-for-profit fund provider with an all volunteer staff. And the top managers in the fund business are as rare as top professional athletes. In case you’re thinking that top athletes make way more than top fund managers, you should check the Forbes list of billionaires. Lots of fund managers. Very few athletes. (Basketball titan LeBron James made $64.8 Million in 2015. Hedge fund titan Steve Cohen made $1.5 Billion.)
But here’s the bad news for fund investors. Regardless of whether your superstar manager delivers on his promise of beating the market, you still have to compensate him as if he did. That’s because of the fee structure built into the business model of every fund company. Fees are not based on performance. They’re based on assets under management (AUM). The fund gets paid up front, no matter what. You only get value for your fee if the fund beats the market by a large enough margin to cover fund expenses. Otherwise, you’d be better off in a low cost index fund.
Granted, if a fund under-performs for too long, clients will eventually bail and the manager’s pay will be cut. But those who stick around will continue to pay full fees, up front, every year.
Enter Smart Beta
Now imagine an investment product that only charges a fee when it actually outperforms its benchmark. This would have two obvious benefits right off the bat. First, it would create a strong incentive for the people who manage the fund to pay attention to what they’re doing. And second, it would remove at least some of the risk borne by the investor, by eliminating the obligation to pay up when performance is sub-par. Here’s what ETF Strategy, a U.K. based webiste, had to say about the launch of ERI Scientific Beta’s product:
“ERI Scientific Beta, the indexing venture launched by Paris-based academic institution EDHEC-Risk Institute, has unveiled a series of ‘multi-strategy smart factor indices’. The smart beta indices allow investors to gain exposure to desired risk factors while at the same time benefitting from index diversification.
Underpinned by research conducted by the highly acclaimed EDHEC-Risk Institute, the indices are available for all developed world geographical regions including USA, UK, Eurozone, Developed Europe ex UK, Japan, Developed Asia Pacific ex Japan, Developed ex USA, Developed ex UK and Developed.
The indices maximise the diversification of strategy-specific risks and as such provide performance that is on average 68% better than that of traditional factor indices, based on an historical comparison of Sharpe Ratios for US large-cap portfolios.
In addition to superior risk-adjusted performance, all of the indices show positive excess returns in the long term compared to cap-weighted indices. Indices which stand out include the High Value strategy, with an annualised relative return of 4.70%, the Mid Cap strategy (4.45%), the Mid Liquidity strategy (4.25%), the High Momentum strategy (3.56%) and the Low Volatility strategy (2.90%). These factor exposures correspond to risk factors that are considered in the financial literature to be well rewarded, and as such are often favoured by investors in the construction of their long-term equity allocation.
The launch comes just over a week after the venture announced that all 2,958 smart beta indices available on its platform would available with full transparency. This transparency ensures the indices are fully compliant with ESMA’s recommendations on the transparency of financial indices.
Noël Amenc, Director of EDHEC-Risk Institute and CEO of ERI Scientific Beta, said: ‘EDHEC-Risk Institute has been calling for many years for free access for investors to data relating to reference indices. We believe that making information available, not only on returns but also on the weighting of the stocks in the indices and their historical composition, is essential for investors to be able to carry out their due diligence on those indices with full independence. To our knowledge, ERI Scientific Beta is the only provider to offer this full transparency.’
Furthermore, indicating confidence in the robustness of their indices, ERI Scientific Beta has recently announced a shake-up to its fee charging arrangements. The new proposal allows investors to request a pure performance fee structure that levies fees only if the flagship Scientific Beta Multi-Beta Multi-Strategy indices has outperformed its market cap-weighted benchmark.”
Pay For Performance
ERI Scientific Beta recently implemented this pay-for-performance pricing model for institutional investors who use their Smart Beta indexes. Clients who opt in will pay no management fees based on the amount of money invested. They will only pay when the product they buy actually beats its benchmark. When the product delivers market-beating performance, ERI will take 20% of the excess return.
Lower management fees are good news for investors, since research shows that fees are the best predictor of future fund returns. When you add in the “hidden costs” of smart beta, such as stretches of underperformance compared to the benchmark, and poor timing by impatient or uninformed investors, the new pricing model has enormous potential benefits.
Making It Easier To Avoid Mistakes
According to a report by Morningstar, the advantages of smart beta investing are often compromised by not-so-smart investor behavior – buying high and selling low. “The biggest costs investors tend to incur are a product of their own bad behavior,” the report says.
Paying nothing during bouts of under-performance may keep investors from becoming impatient and bailing out, just as the fund is about to start outperforming.
Now The Bad News
If you’re thinking “this can’t possibly be true,” you’re correct. While it’s true that ERI is offering this innovative fee arrangement to institutional clients who qualify, you’re probably not one of them. And you probably never will be. That’s because this innovation represents a threat to the investment profession and the traditional business model that underpins it. Why would a mutual fund or ETF provider put their profit margins at risk by doing something as foolish and reckless as offering a performance guarantee, when they can get all the business they want without it?
ERI is offering this guarantee because they believe in their smart beta products, and they are willing to gamble their reputation and their bottom line on it. But the rest of the investment industry does not suffer from this performance affliction. What they are selling is an illusion, a chance to beat the market, but you still have to pay no matter what. Like the carnival barker says, “you pay your money and you take your chances.”