After spending over 20 years in the asset management business, our founder and CEO Peter Kraus came to the conclusion that there were too many active managers managing too much money. He observed that active managers had a hard time remaining aware of their own capacity constraints, largely because of the way they were paid. They’re human beings, and human beings respond to incentives.
The rise of so-called “passive” investing and index-tracking ETFs bifurcated the industry in its most important way to date. Before passive products became widely available, actively managed products were the only option for most investors. Passive products offer investors exposure to the market (commonly referred to as beta), and nothing more. Active products purport to offer investors a shot at returns that exceed the market (excess returns, commonly referred to as alpha). But now that both are ubiquitous, the unique value proposition of each is clear: passive offers a return that approximates the market (beta), and active offers a chance at beating the market (alpha).
Unfortunately, most active managers don’t beat their benchmarks. Take two examples by category: over the last 15 years 84% of domestic U.S. equity funds and 98% of investment-grade long fixed income funds respectively were outperformed by their benchmarks1. In other words, the very objective of active funds – outperformance of benchmarks – was rarely achieved.
The elephant in the room is the fact that no one should be surprised by this outcome. No one should be surprised because the entire active management industry is designed to fail.
Almost all active investment products charge some version of a fixed fee on assets. You, the investor, pay a percent of the assets you invest in fees. A simple example is illustrative. Let’s say you invest $100 in a fund, and the fee is 1%. With zero performance, you still pay $1 in fees (1% x $100 = $1) per year. Performance doesn’t factor into the equation because the fee is based entirely on assets. Now let’s say that the manager’s benchmark was 5%. And let’s say that the manager beats their benchmark, and generates a 10% return. The manager now has $110 under management (10% x $100 = $10, $10 + $100 = $110). And with $110 instead of $100, the manager gets to collect a higher fee, $1.10 (1% x $110 = $1.10).
But what if the manager raised another $100 from a different investor, so that they now had $200 ($100 + $100 = $200) under management? For simplicity, let’s assume that since the manager didn’t focus on investing, they produced a 0% return. Well, the fee is still 1%, but now instead of 1% of $100…it’s 1% of $200! That’s $2! The manager is now collecting almost double the fee they received when they were managing half as much money but were beating their benchmark (a measly $1.10). So what is this hypothetical manager more incentivized to do, perform or raise more assets?
Of course in reality it’s not so simple. It’s not an either / or choice and it’s hard to raise new money with no performance. But we think the general point still holds – managers working under fixed fee models are far more incentivized to raise and maintain assets than they are to perform.
Active managers shouldn’t be able to make more money just by managing more money. They should have to perform. But because fixed fees ensure that they can do just that, managers are incentivized to increase and maintain assets under management, not to produce outperformance.
Right about now you’re probably saying that this is crazy. It can’t possibly be the case that an entire industry is set up to fail. Well, I believe it’s the truth. The math is simple. And if you believe that the behavior of human beings is shaped at least in part by economic incentives, then you should not be the least bit surprised that many active managers don’t control their capacity (they just keep raising money, or battle to maintain the money they have), and therefore struggle to produce alpha.
But what if a firm were willing to make its profitability dependent on whether or not its clients made money?
What if the humans in the firm who were responsible for creating alpha were paid when they did so? This would align the firm’s interests with its clients. What if that firm and those humans were completely explicit about their objectives and how they would pursue them? This would leave no doubt about what the firm’s incentives are.
We intend for Aperture to be the answer to these questions. We identify Humans who are Explicit about how they invest, who are also Aligned with their clients. We accomplish this by turning the perverse incentives of the industry’s traditional business model on its head. Aperture charges minimum fees equivalent to those of typical passive ETFs in the same categories. This basically covers our base salaries and non-compensation expenses. When we exceed our benchmarks – and only when we exceed our benchmarks – we charge an additional performance-linked fee. Along with our manager compensation structure, these economics help to ensure that we only make money when we do what we are supposed to do for our clients – generate alpha. Investors should be able to trust us because our incentives are designed to be clearly aligned with theirs.
Our founder and CEO Peter Kraus puts it this way: “One thing I know for certain is that a manager can’t go wrong doing the right thing for his or her clients. In the end, that’s really what this business is all about – the trust that clients have in us.”