PERFORMANCE FEE STRUCTURE REVIEW. Fresno County Employees Retirement Association. October 1, 2014

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1 PERFORMANCE FEE STRUCTURE REVIEW Fresno County Employees Retirement Association October 1, 2014 SEATTLE LOS ANGELES

2 COSTS ATE MY ALPHA Whenever we see a short term negative outcome we remind ourselves that the risks we re running are supposed to be compensated But costs are different from the other negative experiences we have: there s no upside. They only ever reduce return. -Ian Toner in Costs Ate My Alpha 2

3 MANAGEMENT FEES: IGNORANCE IS NOT BLISS The largest costs of operating a Defined Benefit Plan are Management Fees Prudently managing these costs is a critical component of the fiduciary process FCERA s fiscal year 2013 management fees totaled $14.6 million 1 Wurts & Associates is mindful of these costs and works to minimize fees utilizing a variety of methods including: Employment of passive management to manage costs where appropriate Transition management to minimize transaction costs Securities lending to generate income to offset costs Negotiating the most favorable terms possible 1 According to FCERA s 2013 Comprehensive Annual Financial Report 3

4 MANAGEMENT FEES CERTAINLY! When we feel that active management is the prudent decision, how should we pay for it? Typical Fee Structures for separate account mandates are tiered: FCERA s Mondrian Emerging Markets Portfolio of $300 million: Fee (%) Market Value Fee Estimate ($) 1.00% on first $25 million $250, % on next $50 million $500, % on remainder $225.3 Million $1,352,000 Market-Weighted Cost: 70 Basis Points Annual Fee Estimate: $2,102,000 4

5 ALTERNATIVE TO ASSET- BASED FLAT FEES In certain cases the flat-rate fee structure can be improved in order to minimize fees when the investment manager is not generating the performance to justify the additional cost Under a performance-based fee schedule: Managers make more when their performance exceeds the excess return target Managers make less when their performance lags the excess return target Managers make their normal fee when their performance matches the excess return target 25% AJO vs. R1000 Value Rolling 5 Year Performance 20% 15% 10% 5% 0% -5% -10% Excess AJO Rolling 5 Year Russell 1000 Value Rolling 5 Year 5

6 BENEFITS OF PERFORMANCE- BASED FEES Active management has proven to be successful in certain cases, but it is imperative to prudently manage costs Many managers utilize Most Favored Nation status as a way to avoid assetbased fee negotiations under traditional static fee structures Even the best of managers will underperform in some periods; a performance based fee helps negate the impact of negative excess returns Median Manager Return and Excess Return By Asset Class 1 10 year annualized 15 bp Cost as % 15 bp Cost as % Total Return Excess Return ending 12/13 of Total Return of Excess Return Domestic Equity 9.24% 1.84% 1.6% 8.2% International Equity 8.50% 1.10% 1.8% 13.6% EM Equity 12.69% 1.17% 1.2% 12.8% Domestic Fixed Income 5.00% 0.46% 3.0% 32.6% Global Fixed Income 5.08% 0.93% 3.0% 16.1% 1 Source: evestment Alliance 6

7 CONSTRUCTING A PERFORMANCE- BASED FEE Since passive index replication is very low cost, it is logical to only pay for excess performance when it is actually earned To achieve this, we utilize the following linear performance based fee equation: NNNNNNNNNNNN FFFFFF BBBBBBBB FFFFFF RRRRRRRRRRRRRRRR EEEEEEEEEEEE RRRRRRRRRRRR Performance Based Fee Calculation (PPPPPPPPPPPPPPPPPP RRRRRRRRRRRR BBBBBBBBBBBBBBBBB RRRRRRRRRRRR BBBBBBBB FFFFFF) Definitions: Normal Fee: Stated asset based fee for the portfolio Base Fee: Lowest fee the manager will be paid (during underperformance). Negotiable. Required Excess Return: Managers often state their excess return targets during pitches or in marketing materials. This is the amount the manager must outperform by in order to earn their normal fee. Portfolio Return: Gross of fee return for the entire portfolio Maximum Fee = (2 * Normal Fee) Base Fee By making the maximum fee a function of the minimum fee, upside is directly tied to the minimum fee. If managers have confidence in their strategy, they will prefer to use a lower minimum fee which generates a higher maximum fee they can earn. 7

8 CONSTRUCTING A PERFORMANCE- BASED FEE Utilizing the recently agreed to Brandywine Global Sovereign Portfolio Fee Schedule: 70 Performance vs. Asset Based Fees 60 Total Fee (Basis Points) Minimum fee (10 basis points) paid when matching or falling below the benchmark. Manager receives the normal fee (36 basis points) when the manager achieves their target excess return requirement over the benchmark (180 basis points). Maximum fee (63 basis points) is paid at the threshold determined by the equation (2 * Normal fee base fee). In this case, the threshold is reached at 3.8% of outperformance. 0 Relative Performance Performanced Based Fee Asset Based Fee *Relative Performance is the portfolio return less the benchmark return less the base fee. 8

9 CURRENT INCENTIVE FEE ARRANGEMENTS Strategy Base Fee (Minimum Fee) Normal Fee** Maximum Fee Required Excess Return Trailing Relative Performance* Artisan 0.30% 0.64% 0.99% 2.25% 1.5% Brandywine 0.10% 0.36% 0.63% 1.80% N/A RAFI 0.12% 0.23% 0.35% 2.00% 2.1% Systematic 0.35% 0.73% 1.11% 2.50% -0.2% Waddell & Reed 0.25% 0.44% 0.63% 2.25% -0.1% WAMCO 0.10% 0.24% 0.38% 0.40% N/A *The look-back period is 5 years for all managers; if a manager does not have 5 years of history, the since inception return will be utilized until the five year mark is reached. WAMCO is the only manager that has reached the five year as of June 30, **Normal fees are calculated based off the managers stated fee schedule which are tiered by assets. 9

10 CURRENT ASSET BASED FEES Account Fee Schedule Market Value Estimated Annual Fee Estimated Annual Fee (%) Aronson Johnson Ortiz 0.30% $114,992,153 $344, % Kalmar 1.00% of First $10.0 Mil, 0.88% of Next $10.0 Mil, 0.75% of Next $500.0 Mil $66,266,397 $534, % Loomis Sayles 0.21% $362,837,928 $743, % Mondrian Emerging Markets 1.00% of First $25.0 Mil, 0.75% of Next $50.0 Mil, 0.60% of Next $500.0 Mil $300,293,697 $1,976, % Mondrian International Small Cap 0.85% of First $25.0 Mil, 0.65% of Next $50.0 Mil, 0.63% of Next $50.0 Mil, 0.60% of Next $500.0 Mil $128,334,921 $870, % Wellington 0.32% on First $250 Mil, 0.30% on Next $500 Mil $117,757,535 $376, % Winslow Capital 0.25% $113,441,706 $283, % All data as of 6/30/