The ingredients of active fund prices are largely impossible to discern, but Richard Goddard, of Fund-X SA, says there is innovation in the industry ...
Would you buy a cat in a sack? No? Well, that is pretty much what you are doing when you buy most actively managed mutual funds on the public market. The ongoing costs of investment funds, the so-called total expense ratio (TER), are mostly impossible for investors to foresee. Not only that but there are also no industry standards or regulations requiring a fund manager to forecast, or at least to disclose, actual costs on a regular basis. This is all the more surprising in a heavily regulated industry where fees and expenses impact directly on performance, arguably the core value of the product.
Another strange feature of costs in actively managed mutual funds is the fact that expenses themselves are rarely actively managed. Perhaps this is related to the fact that they are not systematically forecast or disclosed? Investors might well ask whether it is rational to contribute to million dollar bonuses to their fund managers in expectation of a few basis points of alpha, when some basic financial management can contribute even more. Is this situation beginning to change?
There are signs of life in the area of fund expenses, which is encouraging given that they cost European investors tens of billions of dollars a year. Interestingly, despite a flurry of regulations, innovation is coming less from regulators and more from within the industry.
This article looks at a few examples of such innovation in the areas of disclosure, structuring and reporting of expenses.
First of all, disclosure. The International Organisation of Securities Commissions (IOSCO) published in 2004 a report, Elements of International Regulatory Standards on Fees and Expenses of Investment Funds. It concludes that “all regulators consider that it is appropriate and necessary to take regulatory steps in the area of fees and expenses”, but limits itself to identifying “common international best practice standards”. The European Commission recommendation of 27 April 2004 merely “invites” the member states to allow the inclusion of the TER in the simplified prospectus.
European regulators have duly required TER publication in the simplified prospectus of Ucits funds, but some domestic regulators have gone further and required it also in annual and
semi-annual reports. An example of an industry participant positively taking advantage of this trend is Ikano Funds. Its annual report in 2006 devotes an entire page to TER disclosure broken down by component and by share class, and showing variances to benchmark TERs obtained from Lipper Fitzrovia. According to Alan Ridgway, deputy managing director of Ikano Funds, TERs
which are both transparent and competitive represent a distinct marketing advantage. There is even a semi-annnual update on the website.
Some fund managers publish TERs on a monthly basis in their factsheets, which can also invariably be found on their website. In cases like that of JP Morgan Funds, this is simplified by the fact that they have ‘fixed’ their fund expenses by having not only a stated management fee, but also a fixed amount for operating and administrative fees. This is part of a wider trend to give investors simplicity and certainty of TERs. In the past, many fund managers “capped” expenses on an ad hoc or systematic basis. The current movement is towards a more “all-in” type of structure, as evidenced by the largest Luxembourg fund complexes such as UBS (truly all-in) and BlackRock, which introduced as recently as July 2007 a variation on the fixed service fee which excludes custody fees.
The move to more “all-in” types of fee structures is also leading to a more disciplined approach to managing fund-related expenses in the industry. According to Adam Fairhead, global head of product development at HSBC Investments, understanding where fund expenses come from supports business and product development and planning, as well as client service, compliance and corporate governance. This is especially the case if costs can be broken down even to the level of country of distribution by share class – which enables better decisions on which funds and share classes to launch, where and at what price.
In conclusion, significant changes are quietly happening in the huge and under-exploited area of managing and disclosing the expenses of public, actively managed investment funds.
According to Daniela Klasen-Martin, the chair of the TER Working Group of the Luxembourg Investment Fund Association, European regulators are likely to become more prescriptive on consistency of expense calculation and disclosure. It is therefore up to the industry and its trade bodies to anticipate any regulatory changes through continued but more concerted thought leadership and action.
• Richard Goddard is chairman, Fund-X SA, a Luxembourg-based company specialising in the outsourcing of fund expense monitoring and reporting
© 2008 funds europe