Active Management Fees and Alignment of Interests – Revisited

By Chris Bingaman, CFA

January 1, 2016

We described our approach to setting investment management fees and how we link those fees to our internal return goals in our 2011 white paper, “Active Management Fees and Alignment of Interests”, available on our website (www.diamond-hill.com). Specifically, we noted that 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.  The fee should also reflect a fair split of economics between the client and the investment manager.

We periodically review available market information to ensure that our fees and excess return goals continue to meet the standards mentioned above. A recent review indicated that it is appropriate to lower the management fee for our Large Cap strategy by 5 basis points to 50 basis points, effective January 1, 2016 (see tables below).

Large Cap Strategy Fee Reduction

We are committed to always maintaining proper alignment of our interests with those of our clients. With that in mind, the majority of incentive compensation potential for our portfolio managers is based on quantitative, pre-determined goals for investment results.  These goals, measured over rolling five-year periods, include:

  1. An absolute return objective based on inflation plus a normal real equity return.
  2. Sufficient outperformance, net of fees, over a relevant passive benchmark.
  3. Top quartile results in the relevant peer group.

We believe that goals and fees must be considered collectively and should be aligned with one another. Specifically, goals two (relative) and three (peer group) are directly linked as the relative goal, net of fees, is set at a level which we expect will approximate top quartile peer group results over a typical rolling five-year period.

With this in mind, we believe it is appropriate to reduce the management fee for our Large Cap strategy from 55 to 50 basis points. Since our management fees represent 25% of our expected gross value-add, this reduction lowers the margin of outperformance necessary to achieve our relative (vs. benchmark) goal, which we believe will also better align it with our top quartile peer group goal.

Value-Add Gross Management Fee Value-Add Net
Large Cap 200 basis points 50 basis points 150 points

Variable Fee Option

Because future results are uncertain, we also offer our clients a performance-based fee alternative to our standard, fixed fee schedule that shares similarly in the outperformance over time. Under this performance fee schedule, the annual base fee is 20 basis points. At the end of a five-year period, we will assess our relative performance over that period and receive 25% of any return greater than the benchmark (after deducting the 20 basis points base fee). 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.

With the 20 basis point base fee acting as the floor, we impose a ceiling such that our standard fee falls precisely in the middle of the variable fee floor and ceiling. For our Large Cap strategy, the new standard fee of 50 basis points implies a ceiling of 80 basis points, down from a 90 basis point ceiling.

Capacity Limits

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, each manager is incentivized to help 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 over rolling five-year periods.

In June 2015, we closed the Diamond Hill Long-Short Fund to most new investors, and at the end of December 2015, we closed the Diamond Hill Small Cap Fund to most new investors. The Long-Short and Small Cap Funds had $4.2 billion and $1.8 billion in assets under management, respectively, when the portfolio managers decided to close.  We will continue to closely monitor assets in all of our investment strategies and close strategies when in the best interest of our existing clients.

Conclusion

Our primary focus is always on achieving value-added results for our existing clients. We believe the best way to achieve that goal is to manage relatively concentrated, high conviction portfolios constructed independent of benchmark weights.  Our intrinsic value investment philosophy is shared by all of our portfolio managers, allowing us to apply our investment discipline consistently across all strategies. Significant personal investment in our strategies helps to eliminate conflicts of interest, and portfolio manager incentives are structured to reward the long-term success of our clients.  We are pleased to be able to lower the management fee for our Large Cap strategy from 55 to 50 basis points, and we will continue to periodically review our investment goals and fees with the best interests of clients at the forefront of our minds.
 

Originally published on January 1, 2016

The views expressed are those of the author as of January 2016, are subject to change, and may differ from the views of other members of the firm or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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