24 November 2016
Worth the money
Time to investigate fund management fees.
by Frank O’Nomics
Do you really know how well your investments are performing?
What is an acceptable profit margin? Clearly, this differs from industry to industry, with energy providers having been castigated for achieving profit margins of just 4%. In a free market excessive profits are usually short-lived, as the returns prompt more companies to enter and competition quickly brings about a reduction in prices. Consider then the fund management industry, which has for the last few years been able to achieve a profit margin of, on average, close to 40%, with this margin increasing, rather than receding, over time. It is not surprising that this situation has prompted the attentions of the Financial Conduct Authority – indeed, we should really ask what took them so long. The results of their investigations raise some important issues for investors which should prompt them to ask questions of themselves, and their fund managers. We are all being heavily charged by those who manage our investments, but we are not necessarily getting returns commensurate with those charges. The phrase “a rising tide floats all ships” best describes funds delivering positive returns in a bull market, but those returns may not be impressive when compared with a proper benchmark, and we may be better putting our money into a fund that mirrors an index and charges significantly less.
Let’s look at the numbers. The UK fund management industry is the second largest in the world, looking after £7 trillion in assets, £3 trillion of which are in pension funds. Most investors do not spend much time looking at the fees that are being charged on these investments, with many individual investors (around half of them according to the FCA) not even aware that they get charged an annual fee – which is strange given how reluctant most are to pay for any advice when looking to choose a pension or investment plan.
On an annual basis the charges may not look like a lot, with so-called “active” funds (who employee fund managers and try to beat the market) charging on average of just under 1%, and “passive” funds (which just track an index) round 0.15%. However, over time these charges can have a significant cumulative effect. Most rational individuals would have little problem with charges if they meant getting healthy returns overall, but the FCA’s study suggests that investors are not getting value for money, and in particular high charges for active management are not being justified by high returns. Even in the case of passive funds, levels of performance are being questioned, but for the active funds it seems that in many cases investors are paying active sized fees for passive type performance.
In fact it is worse than that. The FCA found that a typical passive fund, with £20,000 invested, would earn £9,455 more over a twenty-year period than a typical active fund. Further, when fees were taken into account that difference is over £14,439, or 44%. Those fees are also a matter for question, as over and above the annual management charge, there is an extensive list of others, some of which are referred to as “administration fees” with more as transaction costs hidden in the activities of the fund, such as bid-offer spreads, FX fees, etc.
For the FCA there is a long list of issues to be addressed, going beyond a lack of clarity over the full costs of funds. Part of their concerns relate to price clustering. It seems that levels of active management fees are remarkably similar, regardless of the size of the fund. Profit margins would suggest that this level has not been arrived at by competition. There should be significant incentives for funds assets to be pooled, in that this should reduce the overall costs of running them (it costs little more to run a £20 billion fund than it does a £1billion fund), but the charges to the investors seem to show no benefits from economics of scale. Far be it from me to suggest collusion, but the FCA will decide in the next few months whether to refer the industry to the Competition and Markets Authority. They are also concerned that funds do not clearly state their objectives, or have a suitable benchmark against which investors can assess their performance. The irony of this is that, since The Retail Distribution Review in 2012, investors have had to disclose their financial objectives together with their appetite for risk to financial advisors when opening an account.
The FCA’s solution has stopped short of putting a cap on fund management fees – FCA Head Andrew Bailey sees this as a “measure of last resort and…not encouraging competition in the market”. They do, however, propose that fund managers publish a single “all-in” level of fees that includes perhaps previously opaque transaction costs and everything that investor’s money has been spent on, so that investors can more accurately compare performance. Fund managers are encouraged to be clearer about a particular fund’s objectives, and the benchmarks against which their performance should be measured. We should not be surprised that, on average, active funds will underperform the market, as for every winner there will be a loser and the effect of fees will mean that the sum total will be negative. What we are trying to do is to find those fund managers who are consistently on the winning side and invest in their funds accordingly. What the FCA report shows is that there are very few fund managers who have been able to deliver that consistent performance. It may be that the nature of their remuneration has arguably encouraged them to take greater risk than might be warranted. Some firms, notably Woodford Investment Management, have moved away from paying fund managers bonuses in the belief that they are ineffective in influencing the right behaviour.
The FCA report, and its recommendations, may be a significant step towards greater clarity, and, hopefully, lower fees. The industry itself now has the chance to take steps to address the issues ahead of any further review, and by doing so to improve its standing in the views of the public. In 2014 a survey by PwC found that just 12% of the public trusted fund managers, compared with 32% for bankers. The rest will be up to pension funds and individual investors demanding to know what they are getting for their money. A combination of poor active fund performance and the impact of charges has helped to push the level of assets under management in passive funds up five fold over the last 10 years, so that they now account for 23% of the total. If we are putting money into an active fund that is, after costs, significantly underperforming an appropriate index, we will only have ourselves to blame.
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