ARC suggested a practical alternative is to consider the potential for outperformance of a benchmark inherent in the investment style being employed.
It said: “This outperformance potential is a function of the size of the active bets made by the DFM. The greater the divergence between portfolio composition and benchmark construction, the greater potential the portfolio has to outperform (or underperform) its benchmark.”
The note suggests that in the absence of an agreed Value Capture Ratio, the quantum of fee payable for applied research can be calculated as a function of the actual (or expected) size of active bets by the DFM, measured statistically by tracking error.
ARC said that the selection of the correct multiplication factor for any given portfolio requires an understanding of the nature of the investment philosophy and process of the DFM and the specific portfolio mandate. However, as a rule of thumb, it believes that an investor might use a factor of 0.25 times the tracking error to give a percentage charge taken from the value of the portfolio.
The note adds: “Research costs money but brings opportunity. A fair fee is one that delivers value for money, where each DFM is paid a fair price for providing investment administration services, financial market access and for applying their investment knowledge and skills to enhancing an investor’s wealth.”
ARC managing director Graham Harrison said: “Discussion of this subject is in its infancy but with Mifid II fee disclosures just around the corner and continuing focus by the media on the low fees charged by ETFs, the question of whether a DFM fee is fair or not is likely to be something that the majority of DFM investors want to consider.”
