Billions In Fee Revenue Up For Grabs?
Pension funds are paying more for fixed-income managers as they shift from traditional core and core-plus strategies to alternatives such as bank loans and unconstrained bond funds. With plan sponsors willing to pay higher fees in exchange for better returns, consultants say asset managers have a particular opportunity to gain—or lose—client assets and fee revenue.
Nontraditional fixed-income strategies have grown in popularity among pension funds recently, a trend that has accelerated over the past year, consultants say. iiSEARCHES’ data illustrates this: since June 25, the service has captured 10 new searches for untraditional fixed-income managers totaling $1.04 billion, while 36 mandates have been awarded to the tune of $3.76 billion. These include commitments to bank loans, high-yield, direct lending, emerging markets debt, and other types of nontraditional fixed-income strategies. During the same period in 2012, iiSEARCHES recorded no new searches and just 11 new hires comprising $1.73 billion. According to research firm Cerulli Associates,U.S.-based intermediate-term bond funds saw outflows of $5.6 billion in the second quarter, while investors poured $30.4 billion into bank loan strategies and $27.8 billion into nontraditional bond funds.
Investors that have jumped into alternative fixed-income have had to accept higher management fees. A recent report from Callan Associates found that fund sponsors’ fees for U.S. fixed income have grown by 12% since 2008, while non-U.S. fixed-income fees have increased by 54% (MMI, 9/19). “The biggest cause of the increase has been the trend of plan sponsors to explore other investment areas outside of core and core-plus,” said Steven Center, v.p. and fixed-income consultant at Callan.
Consultants say asset managers typically charge 20-40 basis points for core fixed-income strategies. In comparison, they estimate that unconstrained bond strategies cost around 50 bps, while bank loan funds can be had for 65 bps and high yield for 80 bps. Direct lending strategies can cost 100 bps or more. “Opportunistic and unconstrained strategies can really cost more than double what core does,” Center said. “And I’ve never seen [direct lending] cost less than 100 bps.”
Although pension funds have been pushing back against asset managers’ high fees for certain asset classes of late (MMI, 05/10), many have swallowed the costs associated with alternative fixed income. “Funds are willing to pay managers more for strategies that have expectations of higher return and that concentrate exposure to areas where there’s the best risk-adjusted return,” said Erik Knutzen, partner at consulting firm NEPC. One such fund, the $3.6 billion Ventura County Employees’ Retirement Association, recently moved approximately $245 million of its investments with Western Asset Management from the firm’s active U.S. fixed-income strategy to its Total Return Unconstrained Bond Fund (MMI, 06/18). Retirement Administrator Donald Kendig said his fund’s consultant, Hewitt EnnisKnupp,was able to negotiate the fee level down to 40 bps, but that it’s still costing Ventura County more than a traditional core strategy would. The fund also has an unconstrained bond mandate with Loomis Sayles, for which it pays 36 bps.
Asset Managers Respond
Asset managers have responded by developing strategies that can cater to the needs of different plan sponsors. Bank loans are popular among pension funds that are concerned about rising interest rates, Center said, while those that remain unsure about the direction of interest rates are more likely to invest in unconstrained bond strategies. Customized solutions offer another option that has become more prominent among larger investors, but those, too, carry high fee levels. “The more customized, the more the fees go up,” said Center. “Customized strategies are always going to be more expensive.” Asset managers have jumped on the bandwagon accordingly. “It seems like every other manager we talk to wants to tell you about a customized solution that they’ve done for fixed income,” said Center.
With no indication that the trend will reverse, consultants say asset management firms have an opportunity with their existing clients and resources. In a recent whitepaper, titled “When the Tide Turns: Building Next Generation Fixed Income Managers,” Casey Quirk predicted that U.S. investors will shift $1 trillion of their assets from traditional fixed-income strategies to “next generation debt strategies,” such as high-yield and loan funds over the next five years. “If you say the average fee on core fixed income is 35 bps, or $3.5 billion, and the average fee on ‘next generation’ fixed-income strategies is 60 bps, or $6 billion—and we’re not even considering hedge funds or private capital fees—that’s an additional $2.5 billion in fee revenue up for grabs,” declared Keith Berlin, senior v.p. and director of global fixed income and credit at Fund Evaluation Group.
The question, as ever, is which firms will win that money. Many in the industry agree that large, multi-product firms—such as PIMCO or BlackRock—may be on the winning end of a shift to more expensive fixed income. Others argue that niche asset managers could claim some of the spoils. “I think these opportunistic strategies demand the resources of large global firms, but exploiting some of the more unique opportunities in less efficient segments of the market can also be the work of boutique firms — very credit-focused or segment-focused boutiques, for example,” Knutzen said.
That could still leave a number of asset managers on the losing side. “The firms that are going to struggle are the ones that are caught in the middle that don’t have the resources to reach those areas of the market,” Knutzen said.
Article originally appeared in Money Management Intelligence. Link here (paywall).