Variable Equity Management Fees and Alignment of Interests
November 16, 2016
The Diamond Hill Mission Statement calls on us to serve our clients by providing investment strategies that deliver lasting value through a shared commitment to our intrinsic value-based investment philosophy, long-term perspective, disciplined approach, and alignment with our clients’ interests. Our mission permeates the way we manage our business, including our consideration of the appropriate fees for our strategies. We ensure the proper alignment of our interests with those of our clients in several ways. Four of the key ways we align interests are:
- Variable fee option
- Link between return goals and management fees
- Capacity limits
- Eat our own cooking
Underlying each of these considerations is the fact that active management costs are higher than passive management costs reflecting higher management fees and higher market impact costs, which are influenced by portfolio size, number of positions, and turnover. At Diamond Hill, our goal is to achieve net of fee returns that exceed passive alternatives over time, despite higher active management costs.
Variable Fee Option
Because future results are uncertain, we offer our clients a variable fee alternative to our standard, fixed fee schedule that shares in outperformance over time. We believe our variable fee structure demonstrates both our conviction in our active management strategies and our alignment with clients’ interests. Under our variable fee schedule, the annual base fee is 20 basis points, similar to a passive alternative. At the end of a five-year period, we will assess our relative performance (net of base fee) and receive 25% of any return greater than the benchmark. We believe that waiting until the end of five years to assess outperformance demonstrates our conviction in our long-term investment philosophy and further differentiates us from our competitors.
Our variable fee structure is outlined in Table 1 below. With the 20 basis point base fee acting as the floor, we impose a ceiling such that our standard fixed base management fee falls precisely in the middle of the variable fee floor and ceiling.
While many managers offer a variable fee in favor of the manager, our variable fee structure is designed to share the benefits of outperformance with the client. Table 2 illustrates hypothetical fees under various scenarios for our Large Cap strategy.
Link between Return Goals and Management Fees
In determining our goals and capacity for each equity strategy, we are always driven by a desire to properly align our interests with those of our clients. With this in mind, we first deduce goals for each of our strategies. From these goals, we then determine our fee schedules. Clients are best served by a fee that is low enough to allow us to achieve meaningful outperformance relative to a passive alternative; yet at the same time, a fee that is high enough to allow us to build and maintain an investment team capable of achieving such results. Likewise, clients are best served by goals that are not only high enough to inspire outstanding performance, but also realistic enough to allow us to pay and retain top investment talent.
The majority of incentive compensation potential for our equity portfolio managers is based on quantitative, pre-determined goals for investment results. These goals, measured over rolling five-year periods, include:
- Sufficient outperformance, net of fees, over a relevant passive benchmark.
- Top quartile results in the relevant peer group.
- An absolute return objective based on inflation plus a normal real equity return.
Importantly, we measure these goals over rolling five-year periods which is consistent with the manner in which we assess the efficacy of our efforts across all aspects of our business, knowing that periods less than five years lack statistical significance. Evaluating our investment returns over rolling five-year periods also minimizes the portfolio manager’s incentive to adopt a more or less risky strategy as year-end approaches, because each year’s investment results will be included in five rolling five-year periods.
We believe that goals and fees must be considered collectively and should be aligned with one another. Specifically the relative outperformance goal and the peer group goal are directly linked as the relative goal, net of fees, is set at a level which we expect will yield top quartile peer group results over a typical rolling five-year period. Next, in the context of these goals, the management fee must be both competitive and reasonable. With this in mind, the management fee under our standard fixed fee schedule represents 25% of the gross value-add goal (outperformance over a passive alternative), which we believe meets our criteria. For a deeper analysis of the relationship between our goals and our fees, please refer to our 2011 white paper “Active Management Fees & Alignment of Interests”.
As strategies grow in terms of assets under management, market impact costs impede a manager’s ability to outperform a passive alternative. The paradox is clear: if a manager has too few assets under management, the economics may limit the internal resources necessary to beat the relevant benchmark; in contrast, too many assets under management may cause a strategy to resemble the benchmark (closet indexing). Conceptually, an ideal size exists for every strategy. At Diamond Hill, the capacity for each strategy is determined by the portfolio manager. Since a majority of our portfolio managers’ incentive compensation is based on investment results (rather than assets under management), each manager is incented to ensure that the strategy remains at a size that will allow strong absolute returns, meaningful outperformance of a passive alternative, and achievement of top quartile investment results.
We Eat Our Own Cooking
Each of our portfolio managers has a significant personal investment in the strategy they manage. By investing heavily alongside our clients, we ensure that portfolio managers will treat their strategies as though they are managing their own money – because they are.
In addition, all Diamond Hill associates, including portfolio managers and research analysts, are prohibited from investing in individual securities or competing firms’ funds in asset classes in which Diamond Hill has an investment strategy. This policy ensures that we are always focused on finding the best ideas for client portfolios, avoiding the conflicts of interest inherent in managing personal accounts.
Originally published November 16, 2016