There are tricks of the trade to keeping investors ignorant when it comes to fees
The Government actuary, David Benison, recently said that in his view the total annual fees of a growth-oriented KiwiSaver fund should be no higher than 0.8 per cent a year of funds under management.
That is, someone with $10,000 in KiwiSaver would be paying $80 a year in fees.
The comment sends an important message to local retail investors - if annual fees at 0.8 per cent are at the top end of the scale, what does that tell us about the appropriateness of the average management expense ratio (MER) of growth-oriented managed funds in New Zealand at more than 2 per cent a year?
Managed funds' annual fees in New Zealand and around the world are way too high and the net effect of these high fees is to give investors a low return after fees comparable with bonds while incurring the risk of equity. Not an ideal situation.
The investing public needs to demand lower fees from fund managers but it appears many do not appreciate the level of annual fees they are paying, let alone the impact of these fees on their return.
Much of the public's ignorance of fees can be blamed on fund managers and financial advisers anxious to preserve the status quo.
The tricks of the trade range from straight-out non-disclosure to spreading the relevant data thinly over 100-page documents.
Then there is the propaganda war - one of the arguments regularly rolled out is that old axiom "you get what you pay for". But as with so much in finance, reality is often the reverse of what it first appears.
In an uncertain investment world one of the few things you can be sure of when you enlist the services of a fund manager is that "you don't get what you pay for" because, obviously, you have paid it to the fund manager.
Indeed, a study by Mark Cahart in the Journal of Finance shows up a one-for-one inverse relationship with fees: the more you pay the lower the return.
Fees are obviously important but intelligent discussion on the subject in New Zealand hit a low point some years ago when one Fund Manager Of The Year argued that management fees didn't affect performance.
If the sum of the average MER of the funds you are investing in, plus the platform fee, plus the monitoring fee exceeds 2 per cent a year, this will in all likelihood mean two-thirds of the extra return of shares over bonds will go in fees. Thus the typical business proposition from costlier advisers is to offer the risk of shares with the return of bonds. Not a great deal.
One of the most worrying aspects of the fee structures typical of managed funds in New Zealand is their open-ended nature in that as well as specifying a base fee, typically 1.5 per cent for a share fund, unit holders are also liable for all the other expenses of the fund.
This typically includes trustee fees, the cost of printing and sending out reports, investor communication, etc. These fees are usually totted up with the management fee and the resulting figure is called locally the MER, or in Britain total expense ratio (TER).
One obvious problem for investors is where investor communication ends and marketing the fund manager's services begins.
The system is open to abuse: some years ago a client asked why, when XYZ fund manager was receiving industry accolades, this firm's products weren't included in the funds we recommended.
I naively thought this might make a good story - XYZ fund manager was apparently almost as popular in New Zealand as Michael Jackson, yet a close look made it clear that performance wasn't good, fees were high and the fund manager didn't offer any passive options.
A critical report was duly prepared and sent to the firm concerned to check for errors of fact.
Shortly after emailing the document the fund manager's expensive-sounding solicitors told me that it wasn't interested in reading the report but if it were published it would sue.
After about a week of communication with the law firm it became obvious the fund manager was not interested in addressing any errors of fact but simply wanted to stop publication of the report, which it succeeded in doing.
Fortunately the firm concerned is no longer around but it occurred to me that the poor unit-holders of those managed funds were probably paying the solicitor's fee of about $500 an hour.
So, perversely, unit-holders were paying to prevent the publication of a report which could bring to their attention the extent to which they were being disadvantaged.
At the same time as David Benison was giving his good advice, one of the leading actuarial firms in London, Lane, Clarke and Peacock (LCP), published an analysis of fund manager fees for British institutional investors.
LCP said many trustees of large pension funds were increasingly considering whether they were receiving value for money from the services provided by their investment managers.
This is despite the fact that they pay a fraction of what retail investors in New Zealand do. The key findings of the LCP study were:
* There has not been a big increase in fees paid by British pension funds despite the increased allocation to alternative asset classes such as venture capital, infrastructure and hedge funds, all of which typically charge much higher fees than your average actively managed share fund.
* Although the LCP study revealed fees paid by British pension funds had not risen, it did highlight that fees vary widely for different asset classes and, of interest to New Zealand investors, the fees payable by a British institution with $150 million to invest are very much lower than what mum and dad with $500,000 can expect to pay.
For example, according to LCP, a passive equity index fund can be had for just 0.13 per cent versus 0.60 per cent for an actively managed share fund.
From a fund manager's point of view, infrastructure is the area to concentrate on as the average fee there is 1.5 per cent ,or more than 10 times, the fee of a passive equity fund.
The report said infrastructure funds also frequently had a performance-related bonus fee on top of the management fee. LCP said: "Trustees should weigh up whether the benefits of making allocations to alternative asset classes justify the high fees that apply."
* The main reason for no increase in average fees has been the marked rise in popularity of low-cost passive index management. LCP estimates about one-third of the assets of British pension funds are managed passively.
LCP says as passive management is available in most equity and bond markets, it offers a viable alternative to active management and trustees should not be willing to pay higher fees unless they believe their fund manager can deliver added value.
But investors should note that investing in passively managed index funds is a bit like hitching a ride for free and if everybody did it, the stock market as a valuation system would cease to function even as badly as it currently does.
Everybody therefore has a responsibility to employ some active managers to ensure markets remain reasonably efficient.
* Relatively few performance-related fee systems are attractive to investors as they generally fail to align investment manager and client interest and end up costing a lot more than a basic active fund arrangement, let alone an indexed based system.
LCP has various issues with performance-related fees including a view that the manager would earn more for achieving the performance objective under a performance-related fee than under a flat fee, base fees payable irrespective of performance tend to be relatively high and, while managers earn a bonus when they perform well, they are often replaced if they underperform and previously paid performance fees are not repayable to the fund.
In New Zealand there are some truly terrible performance-related fee structures where the performance is measured relative to inflation or some relatively low benchmark such as the 90-day bill rate, almost guaranteeing a performance fee will be payable.
One fund had a performance fee payable if the fund outperformed a benchmark return of about 6 per cent when the dividend payment alone of the asset class was 8 per cent. Nasty.
There is a danger fund managers see a performance fee structure as a get-rich-quick-scheme which pays millions in a bull market but does not have to be repaid when markets fall.
This can be compounded by a cosy relationship between company directors and investment managers. It would be interesting to see if shareholders could successfully sue directors of companies that sanction particularly disadvantageous performance fee structures.
The computer running a passive fund doesn't demand a bonus in good years.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request at no charge.
