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Magazine Issues » July-August 2014

DISTRIBUTION: A charged debate

TagsFund charges are back in the spotlight, with 99% of active fund managers in a report underperforming. Fiona Rintoul finds some who think the charging puzzle can be solved, but there is disagreement on how to do it.

In the debate about whether active fund managers add value, each piece of academic research is more damning than the last. The latest salvo from the Pensions Institute at Cass Business School claims that 99% of all equity mutual fund managers are unable to deliver outperformance from stock selection or market timing. It stands to reason that costs and charges associated with this performance are increasingly under scrutiny. 

The Pensions Institute study, which is based on the monthly returns of 516 UK domestic equity mutual funds between 1998 and 2008, reveals an average annual post-fee alpha return of minus 1.44%. Pär Ola Grane, head of market analysis at Alecta, which provides occupational pensions to white-collar workers in Sweden and has SEK 600 billion (€65.5 billion) under management, terms this “anti-alpha”.

“People simply don’t talk about it,” he says. 

“It’s like the lottery. We talk and hear about winners but not about losers.” Worse still, the Pensions Institute study finds that the 1% of fund managers who are able to generate superior performance over and above operating and trading costs extract it all for themselves via fees, leaving nothing for investors. This begins to explain why transparency campaigners believe it is impossible to know whether a fund has performed well or not without full cost transparency. 

“It [the absence of total cost transparency] makes an absolute nonsense of performance, because performance should be after all costs,” says Gina Miller, founder of SCM Private and the True & Fair Campaign, which campaigns for more transparency in the investment industry. 

“You have IFA firms saying that the total cost of investing is the total expense ratio (TER). No, it’s not. How can you give good advice if you don’t know the total cost of investing?”

The Pensions Institute also advocates total cost transparency. As well as its research into performance, the institute recently published a white paper calling for asset managers to disclose all visible and hidden costs ultimately borne by investors. The paper cites research from the Plexus Group, which shows concealed costs can account for up to 85% of a fund’s total transaction costs. 

“No good reasons have been put forward for why all the costs of investment management should not be fully disclosed,” says David Blake, director of the Pensions Institute.

Some in the industry feel this issue is well on the way to being solved. In the UK, for example, the ongoing charges figure (OCF) recommended by the Financial Conduct Authority (FCA) is seen as a solution by the likes of Vanguard, a well-known proponent of cost disclosure. 

“It would be fair to say that in the past the ongoing charges figure has not received universal acceptance within the fund management industry,” says Tom Rampulla, managing director, Vanguard Asset Management. “This has led to inconsistent disclosure of charges, with firms continuing to display different charges on their websites and marketing materials, from AMC (annual management charge) to TER to OCF. The FCA’s and Investment Management Association’s (IMA) drive to achieve real price transparency should do much to build trust and credibility for fund providers who embrace the effort.”

However, the Pensions Institute at Cass Business School does not believe the OCF goes far enough, even when combined with a proposal from the IMA to report all the dealing costs and stamp duty paid when an investment manager buys and sells assets in a fund’s portfolio. 

The institute wants to see full disclosure of all transaction costs and believes this should be introduced in two stages.

Initially, investment managers should be required to report all visible cash costs involving commissions, taxes, fees, custodial charges and acquisitions costs, together with the hidden cash costs of bid-ask spreads, transaction costs underlying funds and the undisclosed revenue. 

Then, once the right IT systems are in place, non-cash costs should also be reported, including market impact, information leakage, market exposure, market timing costs and delay costs.

However, some investment management companies think that calculating some of these costs could be difficult and might produce numbers that investors would struggle to understand. 

“It’s impossible without huge amounts of forensic accounting,” says Jacqueline Lowe, head of UK wholesale at Standard Life Investments. “You might get an overall number but you’d have to be an expert to understand it. At what point are you getting spurious accuracy?”

One example of a tricky area is the involuntary dealing that occurs when investors buy units. Some investment managers adjust for the cost of dealing in the price when new money comes in so as to protect existing investors.  

“We’ve always had a dilution levy,” says Lowe. “In their scenario, we could end up looking more expensive than we were,” she adds.

Alecta’s Grane agrees that transaction costs can be trickier to account for than other costs, particularly in relation to the market impact. 

However, he disputes the notion that total disclosure is impossible.

“We can put people on the moon,” he says. 

The Pensions Institute proposals are broadly in line with what certain other bodies want, such as the Netherlands’ Authority for the Financial Markets (AFM). 

A voluntary standard for the disclosure of pension charges and costs was introduced in the Netherlands in 2011, and there is discussion in the Dutch parliament about adopting legislation on disclosing transaction costs in early 2015. 

“We think that the fund management companies need to put more effort into making information firstly more accessible and simple, and secondly more transparent with regard to the underlying costs,” says Tim Mortelmans, head of the AFM’s supervisory department. “The UCITS KIID [key investor information document] does not require all costs to be made transparent, for example transaction costs. However, these costs can constitute a big part of overall costs.” 

Some managers say they achieve cost transparency by paying some or all of the costs cited by the Pensions Institute out of the AMC. 

“In the interests of transparency, we pay all running costs out of the AMC,” says Rampulla. “We believe this gives you a better understanding of the cost of your investment. It also means that we expect our funds’ AMCs to equal their total ongoing cost.” 

And some managers simply do not believe that the level of disclosure advocated by the likes of the Pensions Institute and the True & Fair Campaign is necessarily helpful.

“What they are getting at is tiny amounts of transactional charges,” says Lowe, at Standard Life Investments. “Some of the proponents [of transparency] are selling a discretionary management service based on tracker funds or ETFs. That’s a different type of investment philosophy. When it comes to active management someone might end up knowing the costs and charges but fail to understand the value.”

In any case, while conceding that in the past disclosure of renewal commission, for example, was less transparent than was ideal, Lowe disputes the idea that some charges are hidden. “Everything comes out in the unit price movement,” she says. “Ultimately, an assessment can be made.” Lowe also sees dangers in over-emphasising charges. It could, she says, result in customers being presented with sub-standard solutions by advisers because they can be made to look cheap, especially as it can be difficult to know what the exact charges are for a derivative or an ETF. 

“A derivative will look cheaper, but the price comes out of the overall return,” she says. 

Of course, underlying the discussion about charges is the accusation that investment managers are ‘coining it in’ at the expense of investors. 

Miller from the True & Fair Campaign claims the average asset management business is around three times as profitable as the average small- to medium-sized business and suggests the industry has been getting away with “legalised fraud”.

Grane at Alecta, puts it another way. “There’s some sort of blindness that easily happens when you’re handling billions of dollars,” he says. “You become oblivious to your own costs.” 

Alecta’s investment management fee is three basis points and there is an additional charge of ten basis points for insurance and administration. Grane says Alecta achieves these low fees by economies of scale and avoiding complexity. The company’s mutual structure also encourages it to share its economies of scale. 

In that spirit, it recently introduced a cap on charges of 75 Swedish krona, or €8, per month for its defined contribution customers. 

“That’s one obvious way to give economies of scale back to customers,” Grane says. “Why does the investment management industry charge people in percentages? Costs are only marginally dependent on volumes under management. We should have a debate about this.”

Some believe the debate about cost transparency contains the seeds of an opportunity. “If the industry did this it would tick so many boxes in terms of increasing trust in the industry,” says Miller. 

“All the data is there. It’s actually not difficult to do.”

Were the industry to grasp that opportunity, it might achieve that Holy Grail of restoring trust. “The biggest challenge facing the industry may also be its biggest opportunity: cost transparency,” says Rampulla.  But will the industry jump at this opportunity? Probably not, seems to be the prevailing view. 

“You should not expect the industry to solve this problem,” says Grane. “The lawmakers must step in.”

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