It is hard to see any correlation between fees and returns, Brent Sheather writes, has anyone seen the Marlboro Man? Photo / 123RF
The global fund management industry is under pressure at the moment, both from their customers and regulators.
We are in an era of low returns and consequently retail investors are starting to realise that paying 2 to 3 per cent per annum in fees, some of which are still not disclosed despite the new regulations, when share markets are priced to return just 6 to 7 per cent per annum is not a particularly good deal.
In fact the forward looking excess return of shares over long bonds is generally estimated to be 3 to 4 per cent per annum.
So the typical investment plan from your friendly private bank, with a 3 per cent per annum total fee structure, effectively delivers to mum and dad the risk of equities with the return of bonds as the fund management industry appropriates the risk premium.
In addition overseas regulators at long last appreciate that they have a critical role in getting a fair deal for retail investors.
In the UK the Financial Conduct Authority (FCA) has recently completed a detailed study of the fund management industry which we will talk about in a later column, but they have summarised their findings in a couple of sentences: "Our evidence suggests that actively managed investments do not outperform their benchmarks after cost and that some active funds offer similar exposure to passive funds but charge significantly more. Some investors are unlikely to ever drive value for money effectively and therefore need strong governance to act on their behalf. Currently this does not appear to be happening contributing to limited price competition for actively managed funds. This results in investors choosing funds that are unlikely to meet their expectations".
This is a game changer from the FCA.
In NZ the FMA has long argued that it will get involved if funds are sold which won't meet client expectations.
As recently as the 13 December the FMA said "the true test of any providers approach....will be whether they can show customers and the FMA that what they do is consistently effective at producing good customer outcomes".
Despite this rhetoric they consistently ignore the fact that investors in share funds should expect the return of a share fund however, due to the impact of annual fees their return in the long run will approximate that of a bond fund.
We saw an extreme example of that the other day when Financial Services Complaints Limited (FSCL) disclosed that they had investigated a complaint from an individual who invested $8,000 in a growth fund through a financial advisor.
Twenty years later the investment was worth $7,000 despite the retail investor paying his financial advisor $1,100 in fees. FSCL said that "one of the major reasons for the unsatisfactory result was that the fund had high fees".
Despite this managed fund not meeting anyone's expectations the FSCL said it couldn't take any action and it doesn't look like the FMA got involved at all.
In fact the FSCL wouldn't even name the fund concerned. Given this adverse environment, both in respect of fees and regulations, it is no surprise that money is fleeing active for passive.
Understandably active managers are on the defensive and pounce on any research, however dubious, that substantiates their flawed business model.
Since 1900 the performance of NZ shares has broadly matched that of the world stockmarket and there have been many periods of underperformance.
There is an old saying, popular with economists, that if you torture data sufficiently it will confess to anything. Readers may remember a recent atrocity whereby a fund manager compared the returns from low risk/low fee KiwiSaver funds with those of high risk/high fee KiwiSaver funds, noted that the funds with higher fees had outperformed and thus concluded that the data showed that fees weren't an issue.
Absent the duress and the obvious problem with this analysis was that the fund manager was comparing risky shares with low risk bonds thus all the dodgy "analysis" confirmed was that shares outperformed bonds and said nothing about fees.
Just recently local fund managers have jumped on some research from Australia which also suggested that high annual fees translated to high returns using five year data from KiwiSaver funds.
Really? Let's dig a bit deeper and to keep things short we will just focus on growth oriented KiwiSaver funds.
The Sorted website lists 38 growth funds and the highest performers over five years, by a country mile, are a locally managed fund with a high weighting in NZ shares and another fund which invests in the first fund.
These two funds have returned about 13.8 per cent per annum for five years versus an average of about 7.78 per cent per annum for the 21 funds which have been going for at least five years.
The third best performing fund returned 9.3 per cent per annum for five years.
So why have these funds done so well I hear you ask?
Is it because they have high fees?
The answer to that question is very simple and it should have been obvious even to managed fund researchers.
It is chiefly because the two funds have, over the five years, had a much higher weighting in NZ shares and not much at all in international stocks whereas the other funds have had a much higher weighting in international stocks.
This asset allocation is typical of boutique NZ fund managers.
The outperformance is thus mainly due to the fact that over the five years ended 30 April 2016 (the latest Sorted data) the NZ stockmarket returned 15.6 per cent per annum versus 8.4 per cent per annum for the world stockmarket in NZ$ terms.
Indeed it is hard to see any correlation between fees and returns because the two funds have average fees of about 1.5 per cent per annum versus an average fee for the group of 1.59 per cent per annum.
There are two further caveats to the Australian research that investors should be aware of and that is firstly, that the funds with really high fees, and there are funds that have fees as high as 2.95 per cent per annum, haven't been going for five years which makes the "high fees equals high returns" conclusion look rather tenuous.
Secondly, any academic will tell you that five years is much too short a time period to draw any conclusion as regards the impact of fees as luck and geographic asset allocation can be far more significant.
Lastly investors should remember than NZ shares don't always outperform.
Since 1900 the performance of NZ shares has broadly matched that of the world stockmarket and there have been many periods of underperformance - to take an extreme example in the five years ended January 2000 NZ shares have returned a total of 53.5 per cent versus 199.9 per cent for the world stockmarket.
Sure some people outperform for a year or five years or even more but sooner or later their luck runs out or some extraordinary factor changes so that their investment process doesn't work so well and, goodness me, they start underperforming due to high fees.
So that's that analysis dispatched into the recycling bin, at least of respect in growth funds.
Contrast this research showing that "high costs equal high returns" with the real world. Numerous research papers show what is pretty obvious to anyone with half a brain and that is the higher the fee the lower the return to the investor, on average.
One of the most widely read of these papers was entitled "On persistence in mutual fund performance" by Mark Carhart, published in the Journal of Finance.
He tested the theory that "mutual fund managers claim that expenses and turnover do not reduce performance".
He found that "expense ratios, portfolio turnover and load fees are significantly and negatively related to performance.
Expense ratios appear to reduce performance a little more than one for one".
He concluded that "while the popular press will no doubt continue to glamorize the best performing fund managers the mundane explanations of strategy and investment costs account for almost all of the important predictability in mutual fund returns".
What's the rationale for focusing on fees?
It is this - given that there are so many people trying to find bargains on the stock market - think institutions, fund managers, retail investors, insider traders, company executives etc etc it is difficult to find bargains.
Sure some people outperform for a year or five years or even more but sooner or later their luck runs out or some extraordinary factor changes so that their investment process doesn't work so well and, goodness me, they start underperforming due to high fees.
The fact that high fees are not good for your wealth unless you are a fund manager is pretty well acknowledged by most but you can bet your retirement that we haven't seen the last of spurious data masquerading as science showing that managed fund returns are independent of fees - a bit like the independent research from cigarette companies showing that there is no correlation between smoking and lung cancer.
Anyone know what the Marlboro Man is doing these days?
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