Investment manager Westwood Holdings Group Inc., in an effort to further innovate and align with investors, has launched its “Sensible Fees” pricing model for three mutual funds operating within its newly-formed Multi-Asset franchise.

The new performance fee structure is available in Westwood’s Alternative Income, High Income and Total Return Funds. The firm suggests its Alternative Income Fund will be the first of its kind to incorporate a performance fee in its corresponding Morningstar Market Neutral category.

Westwood contends that in the aftermath of the 2008 financial crisis, alternative mutual funds have failed to align expense ratios with the risk and return potential of underlying investment strategies and have often been overpriced. “Over the last five years, expenses in most major alternative liquid categories have average fees that range from nearly 40% to 63% of gross returns, which hurts conservative investors looking for low, single-digit returns to diversify bond portfolios. Sensible Fees help mitigate this disconnect, better aligning with the investor by not charging high fees when a fund fails to generate excess returns and only having the investor pay a proportionate fee as a share of valued-added performance,” the company says.

“We believe this new model serves as a catalyst for mutual fund investors at a time when [exchange-traded funds] and index funds may likely disappoint investors due simply to potentially lower market returns over the next 10 years. Sensible Fees funds will enable investors to pay a low index or ETF-like fee while only charging a higher active management fee when fund performance objectives exceed the benchmark,” said Phil DeSantis, head of product management at Westwood in Dallas, Texas, when the new approach was initially offered in conjunction with Westwood’s “best ideas” high-conviction LargeCap Select strategy back in March.

Sensible Fees and aligning with investor goals

Sensible Fees combine a zero or passive-like base fee plus a linear fee directly linked to risk-adjusted outperformance only when it is earned.

In an interview with PLANSPONSOR, DeSantis says there is a disconnect between what asset owners and asset managers are trying to solve for. Getting this in alignment transcends fees; it’s aimed at changing the probability of winning for investors.

“With U.S. Large Cap, the cost of beta sets the base fee. ETFs charge seven to nine basis points on average, but we use a zero-based fee. Then we use alpha to measure outperformance. We wanted to get hyper-specific around that measurement because we want to get paid on real skill, not on taking excessive beta or market risk,” he says. “We charge 30% of alpha, and the client retains 70% of outperformance. We do this over a 1- or 3-year rolling period, with built in clawbacks based on negative performance experiences.”

DeSantis explains that in one of the mutual funds converted from a fixed fee to a performance-based fee—the Alternative Income Fund—the base fee is 35 basis points (bps), “as close as we come to cost of beta.” When solving for the potential of the asset class, Westwood determined that a return 3% or 4% higher than cash would qualify as top percentile outperformance. “We don’t start earning an active fee until we start outperforming the benchmark, up to 4%. We earn 0.67% if we outperform by 2% and 0.99% if we outperform by 4%,” he says. DeSantis notes that the Alternative Income Fund is designed to complement bond funds, which generally have expense ratios of 2.5%.

Bringing investors back to active investing

In August, Morningstar reported that preliminary numbers showed passive U.S. equity assets passed active U.S. equity assets by about $25 billion.

DeSantis comments that in the institutional investment space, business has been done a certain way for a long time, and Westwood’s Sensible Fees construct is new. “Nothing is going to change on a dime. There is an educational process that needs to take place,” he says.

Steve Paddon, head of Distribution at Westwood in Dallas, Texas, says, “I don’t think [our model] is a replacement for passive investing, it’s an alternative. If investors want alpha, our approach aligns with that proposition better. I don’t know that investors that have given up on active will revisit it, but it is a great way for those who want active to get better outcomes.”

According to DeSantis, the alignment of investor and manager interests is a big topic in the institutional market, and he contends that fixed fees in some ways prohibit the pure alignment of interests. “One of the problems in active management is there’s a cyclicality—some years managers outperform, some years they underperform. The mathematical and psychological disconnect has sort of forced institutional investors to take the path of least resistance. The thought is that it’s easier to go passive and not take the risk of active, because fees are an important topic,” he says.

Westwood believes its Sensible Fees model can change the conversation. “We’re active managers whose job is to deliver alpha. All else equal, we can change the probability of outperformance. The investment strategy is the most important thing; our fee model allows us to manage the cyclicality of active management. It sort of levels the playing field with indexing by only paying for the cost of beta and only paying for alpha when it’s occurring. It’s different from paying a fixed fee when the outcome is uncertain,” DeSantis says.

He points to Japan’s Government Pension Investment Fund (GPIF)—the largest in the world—and more recently the University of California moving their portfolios towards the active side as being indicative of the future. “They are asking asset managers to create constructs similar to ours. This is important because the largest pensions in the marketplace can negotiate any fixed fee they want, but see these constructs as a better alignment with their goals,” DeSantis says.

“From a bigger picture, we want to deliver our investment services in the most flexible way to investors—competitive fixed fees and the Sensible Fee model. It is part of our value proposition to offer world-class investment management with fees aligned with investor’s outcomes,” Paddon concludes.