Active management fees – how low can they go?

I could argue that active fees have scope to fall significantly while maintaining a fully functioning active management industry, although (and here come those words again) it depends on what you mean by low. Without overcomplicating the argument, the lower bound of management fees is made up of three basic components:

• The costs associated with production

• Scalability and capacity of assets being managed

• An acceptable return on capital for those involved

Let’s dig a little deeper. The costs of production will vary, but can be very low for an active strategy. To deliver an active strategy simply requires a process for generating a portfolio that is different, or active, to the market.

To illustrate the point, an active strategy could just be a rule-based asset allocation arrangement, for example structuring a portfolio of holdings based on an equal or fundamental weighted basis, which could have very low running costs.

Active fees have scope to fall significantly while maintaining a fully functioning active management industry

It is possible for a highly active strategy to deliver better outcomes over a naive weighting but this would come with an associated increase in costs, which leads to questions around value for money. This might be down to higher volume of inputs or people, or indeed the inputs themselves may cost more; an active strategy will naturally have higher costs than a naive strategy.

Performance v risk

There is another side to this. Any value-based assessment of active management should not solely focus on outperformance but also management of risk as well, ie downside protection.

That aside, it will come as no surprise to note that there is limited evidence to support that increasing costs directly results in the outperformance prospects of a pension scheme. It is also worth noting that high fee strategies are not necessarily high cost strategies. High costs are sometimes interpreted as a perception of skill, which can be somewhat misleading.

It’s been said that active management will always exist in pension schemes as there is no such thing as a truly passive investment; someone makes at least one decision. Furthermore, some may note the link between costs and the number of decisions being taken.

High-quality active strategies can and are run at relatively low costs, but pension schemes should be aware that much of the excess cost in the industry is not correlated to an increase in excess return prospects. 

Of the other components, scalability will tend to vary by product and asset class and will typically have an impact on fees, for example small-cap equities will generally be more expensive than their large-cap brethren. 

Perhaps the thorniest of the three areas is the ‘acceptable’ level of return on capital for active management. The margin in active management, as you would imagine, is very high compared with other industries; The Financial Conduct Authority puts it at around 36 per cent.

There is scope for this to fall but still leave the opportunity to make an attractive return on capital for those involved. However, it comes with a health warning: at some point the margins will become too low to make it attractive for firms or individuals to participate.

It’s not clear where that floor is; it is somewhat below current active management fee levels, but certainly higher than fees paid for passive strategies.

So just how low can they go? Ask your friendly pension scheme active fund manager, but be prepared to hear a familiar couple of words – it depends.

Brian Henderson is Mercer UK's DC and financial wellness leader