Brent Sheather: Fees and Anomalies

Evidence suggests that many intuitional investors have stepped back from paying performance fees in respect of long only equity funds.

This column has long argued that the fee structures prevalent in the retail financial advisory sector are much too high relative to returns.

Assuming 4% from high quality bonds and 7% from shares gives a weighted average return of about 5.5%. So the industry average 1.5-2.5% annual fee implicit in the typical retirement plan solution prepared with advice (1.5% to fund manager plus 0.5-1.0% monitoring fee to an adviser) can see up to 50% of returns skimmed. Equity investors are thus frequently offered the return of bonds with the risk of equities. But high fees have unpleasant side effects over and above the obvious appropriation of wealth and these can be more deleterious than the fees themselves.

For a start industry players frequently overestimate prospective returns so as to show their fees in a better light which can mean that clients overspend, don't save enough for retirement and have unrealistic expectations.

Financial advisors with high fee structures also tend to recommend risky asset allocations on the basis that shares can withstand high fees better than bonds which can have disastrous consequences when stock markets fall and advisors with high annual fees often advocate overly complex solutions and encourage excessive trading on the basis that they need to be seen to be doing something, even if it is the wrong thing. Last but not least, when constructing fixed interest portfolios, advisors often recommend junk debt because low risk bonds, like government stock, can't sustain a high management fee. The combined impact of these factors may be the reason why retail investors often sell out when times get tough.

In the last month two interesting reports have been published highlighting the high fee issue. In its annual European Private Banking survey global consulting group McKinsey argued that reducing the cost of advice and fund management will need to be a priority for European private banks in the future. McKinsey cite changed regulations in Europe as increasing the visibility of fees for retail investors and suggest as a result that the clients of private banks will be increasingly cost conscious. McKinsey recommends new pricing models, increasing the use of passive funds and ensuring that smaller high net worth clients are not "over serviced".

In its global banking survey McKinsey note the threat posed by new entrants to the wealth management industry (financial advisors) in that some offer the service for as low as 15 basis points versus the industry standard charge of at least 100 basis points.

The second report was a review of the KiwiSaver fund managers by the NZ Treasury. The authors said "the level of fees charged to investors has a drastic effect on ultimate returns and therefore retirement income outcomes". Treasury estimates that total KiwiSaver fees in 2014 were 1.95% of total assets and it separates these fees into membership fees and fund management fees. The authors comment "these fees are still very high compared to the fees available to retail investors in the USA.

The USA should be the baseline for lowest fund costs and the current average expense ratio for the 10 largest funds by assets in the USA is 0.22%. These are offered by a range of growth and income funds and dominated by passive index tracking funds."

One of the most ominous findings of the Treasury report and one which should preoccupy the minds of regulators was that when the researchers looked at reasons why people change KiwiSaver provider they found that neither cost nor investment returns significantly influenced peoples decisions.

They noted depressingly that there was no significant relationship between fees and fund flows. The report also added that there was no evidence that the Sorted website's Fund Finder which highlights fees impacted investment decisions. These latter points highlight the naivety of relying on disclosure to protect investors.

This strategy has been discredited numerous times overseas and it is good to see the FMA acknowledging this in a recent speech by Liam Mason, FMA Director of Regulation. Mr Mason said "the traditional approach to disclosure assumed that if all information was available investors would react rationally". He went on to say this was erroneous because it didn't take account of investors biases, avoidances or behaviour.

Last month the financial statements for a group of managed funds was published and they make interesting reading. Two of the funds, the Income Fund and the Global Fund are burdened with high levels of fees because of the performance arrangements they are subject to.

First off looking at the Income Fund its fees, as a percentage of assets, were about 2.0% which is about 4 times the charges of a low cost, local equity index fund. The reason that unit holders in this fund paid the high performance fee is because the performance fee is benchmarked against the 90 day bill rate plus 2.5%, a total of about 5.5%.

For some perspective on how difficult it is to earn that performance fee, or not, the fact sheet discloses that the income yield of the fund, before any capital growth, is around 7% and that almost one-third of the fund is invested in high yield bonds.

What this means is that the performance fee is earnt without the fund's investments having to increase in value. It is also relevant to note that the performance benchmark has just been "extended" from September 1st by 2.5%. Previous to that the fee was benchmarked to returns above the 90 day bill rate.

The Global fund has an estimated total expense ratio, including performance fees, of around 2.6% pa. The performance fee of 1.2% of assets was payable despite the fund underperforming a low cost (Vanguard) world index fund by 2.8% in the twelve months ended 30 September. We estimate that this fund has underperformed Vanguard's world index fund by 5.4% pa in the last two years.

As this column noted about ten years ago best practice as regards performance fees is to ensure that the benchmark is representative of the assets of the portfolio ie a global share fund performance fee should only be earnt if it outperforms the global equity benchmark. In these two cases performance fees appear to be payable because long duration equity funds are benchmarked against a short term fixed interest index. The Global Fund performance fee at the OCR rate plus 5% does not actually look unfair because that is a total return of 8% or so and most experts reckon that global equities are priced to return about 6% but when you have unrepresentative benchmarks anomalies like the one highlighted where a performance fee is payable despite underperforming can occur.

Anecdotal evidence suggests that many instuitional investors have stepped back from paying performance fees in respect of long only equity funds.

The independent directors of two locally listed closed end funds, each with more than $1 billion of assets, have in the last couple of years renegotiated their agreements with the fund manager to exclude a performance fee component. I asked the NZ Super Fund what proportion of its international equity portfolio was invested in index funds and whether, in respect of long only actively managed equity funds it paid performance fees.

Catherine Etheredge, Head of Communications, said that "almost 96% of our holdings in global equities were passive. The only active mandate is in emerging market equities and our arrangement is confidential. Speaking generally however it is common practice for institutional investors to pay fees based on assets under management only, not performance, for long only equities mandates".

So where does that leave us?

The FMA's mandate is to get a fair deal for retail investors and institutional investors don't think performance fees, even when they are calculated fairly, are a good deal. Given that disclosure doesn't work it seems clear that the FMA should put a stop to unfair performance fees either through regulation or a quiet word with fund managers.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.