The first thing you read on the Financial Markets Authority's (FMA) webpage is that its overarching objective is "promoting fair, efficient and transparent financial markets".
In a recent document entitled "A Guide To The FMA's View Of Conduct" the FMA mention that fund managers fees need to be fair on four occasions. However at no time does the FMA define what fair actually means. Perhaps the same people that write politicians speeches also help out at the FMA.
Fees are important to retail investors because high fees reduce returns (obviously) but they are also important to the FMA because they are an impediment to the efficient functioning of financial markets.
Furthermore the FMA's objective of transparency is also relevant because if the public believes it is not being told the whole story (see below) by the financial sector it tends to direct its savings into asset classes it trusts, potentially misallocating capital.
Whilst fund managers and regulators regularly wring their hands about investors leaving their money in the bank or buying residential they should perhaps look to their own actions, or inactions, for a logical explanation of illogical behaviour.
Before we look at the "are funds fees fair" question let's consider the regulatory response to the issue.
Unfortunately the Government and the gurus at the Ministry of Business, Innovation and Employment (MBIE) have decided to limit the FMA's tools in protecting the public from unfair fees to "disclosure" despite the fact that numerous studies show that disclosure doesn't work.
The impotence of disclosure locally, as a protection from fund managers, was illustrated in a recent survey on KiwiSaver by the FMA and the Commission for Financial Capability which found that, despite all the excellent disclosure, 47 per cent of people did not know what fees they were paying, 20 per cent were unsure and a further 15 per cent didn't know what day it was.
There are a number of reasons why retail investors understate the impact of fees but, putting aside the obvious ones like illiteracy and laziness, top of the list is the fact that whilst fund managers disclose they disclose in a way that frames the fees so that they don't look so important (recall that the best way to look short is to stand by a tall person) and in a way that is difficult to understand.
In addition disclosure emboldens funds managers to behave badly in that they know that "if they disclose then anything goes".
Even though disclosure doesn't work, for it to work, all the relevant information needs to be disclosed. Despite the new, all singing, all dancing Financial Conduct Act, this is still not happening in NZ, in a very material way. In researching this article I found two glaring instances where the information presented to unit holders was wrong.
A significant cost incurred by unitholders of any managed fund is the brokerage fees paid to stockbrokers to trade the portfolio. However it is standard practice in NZ and overseas to leave these costs out when calculating the fee structure of the fund.
Furthermore some fund managers include these costs when producing the Statement of Comprehensive Income and others don't.
One fund manager disclosed in the Statement of Comprehensive Income, which no one reads, that the brokerage charges paid to stockbrokers were $3million in 2016 which is material in the context of a $300 million fund. These charges however were omitted from the expense ratio calculated in the investment statement which the regulators tell us is the "go to" document for full disclosure.
The other example of misinformation can be found in the investment statement of one well known fund manager where the manager "estimates" the extent of its performance fees for a number of funds and in every case the "estimate" is materially less than the actual historic performance fees.
Perhaps the best way for a financial advisor to discern what is good behavior and what is not is to look at how professionally managed pensions approach the issue of expenses.
The extent of the difference between actual and estimated is up 2 times. It is hard to understand how this sort egregious misinformation is possible in the post Financial Conduct Act world. The purpose of the Financial Conduct Act is to "promote and facilitate the development of fair, efficient and transparent financial markets and to promote the confidence and informed participation of investors".
Omitting fees that investors have paid and misrepresenting costs doesn't seem "fair or transparent" and probably doesn't "promote confidence" either. It is pretty clear that politicians and law makers at the MBIE could have done a better job here.
One might also reasonably expect some meaningful input on the fee question from the Commission for Financial Capability however all their spokespeople seem to do is smile and avoid saying anything useful. Meanwhile, as the FMA has apparently declined to rule on "fair", retail investors and financial advisors need to step up and make a judgement call. Perhaps the best way for a financial advisor to discern what is good behavior and what is not is to look at how professionally managed pensions approach the issue of expenses.
Hint:They minimize expenses. You don't need an MBA to understand the logic of that approach. Exhibit A, in the definition of "fair fees", is the NZ Government Super Scheme.
The annual report for the Government Super Fund says that minimizing fees is one of its major objectives and despite having a high exposure to expensive funds investing in alternative assets the average expense ratio of the Government Super Fund last year was just 0.60 per cent.
So whilst the FMA and Government haven't defined what is unfair we can follow the money and discern what they consider is fair. That number is just 0.6 per cent. Note however that this fund is closed to new members.
Academics come to the party and, with Morningstar tell us that as performance is fleeting fees are forever so fees are the best indicator of relative performance by asset class. Other research confirms that there is a 1 for 1 negative relationship between fees and returns i.e. on average a 1 per cent annual management fee reduces returns by, wait for it, 1 per cent.
Next up let's check out the average level of fees in some popular, expensive local funds:
So how should we frame these annual fees so that we can properly consider their impact on returns and answer the question as to whether they are fair or not?
Here are some guidelines:
• Academic research tells us that we should expect global equities to outperform long dated bonds by about 3 per cent pa. So annual fees of 3 per cent effectively deliver retail investors the return of bonds with the risk of equities. That doesn't sound like a good deal, let alone fair.
• Looking at returns another way Keith Ambachtsheer, Director Emeritus of the International Centre for Pension Management, writing in the London Financial Times last month, estimates that global equities will return 3.6 per cent a year after inflation, pre tax, pre fees. If inflation is 2 per cent then a 3 per cent fee structure appropriates more than 50% of returns.
That doesn't sound fair either.
• The most popular exchange traded funds in the US have annual fees of between 5 and 10 basis points i.e. between .05 per cent and .1per cent. In this context fees of 3 per cent pa or 300 basis points doesn't sound particularly fair.
• Last but not least the SEC website in the USA tells us that each 1 per cent in annual fees reduces the terminal sum over a 20 year saving period by 18 per cent. So a 3 per cent fee structure which reduces your terminal sum by more than half doesn't sound fair.
Given the above we can probably conclude that annual fees of 2-3 per cent pa aren't fair.
It will be interesting to see how the FMA interprets their role in requiring fund managers to put client's interests first particularly given their objectives outlined at the start of this story.
I'm reminded of the PYE factory which made televisions in Waihi and am thinking that if local fund managers can't deliver the goods in an internationally competitive market maybe some or all should go the way of the PYE factory. In any event hidden subsidies like poor regulation should be withdrawn.