Brent Sheather: Fees gut returns from managed funds

It is difficult to get an objective inside view of the managed funds industry.

Stockbrokers keep quiet about high fees and poor performance for fear they will upset their institutional clients, financial planners have an obvious vested interest in outsized fee structures and the fund management research firms generally limit their deliberations to higher-cost, unlisted managed funds so they aren't likely to put themselves out of a job by saying the sector is bad news either.

Nevertheless, it is probably fair to say that with international interest rates and dividend yields so low, the economics of managed fund investment for retail investors have probably never looked as bad as they do presently.

The managed funds industry is waiting expectantly for a Budget-inspired flow of funds from work-based savings schemes yet we have the ridiculous situation whereby the industry average fee structure consumes almost one-third of the 7 per cent to 8 per cent per annum return one can reasonably expect from a diversified portfolio of bonds and shares.

Faced with a meagre 5 per cent after-fee return from a risky portfolio, no wonder buying the house next door looks attractive to Mum and Dad. The industry's response to critics of high fee structures has ranged from denial to the extraordinary assertion from one fund manager of the year a few years back that fees didn't matter.

In the US, John Bogle, founder of the Vanguard Group which pioneered the offering of low-cost index funds to retail investors, has been an independent and constructive critic of the US$7.5 trillion ($10.5 trillion) US managed fund industry since 1949.

In the January 2005 issue of the Financial Analysts Journal, Bogle reflects on changes in the industry over the past 60 years and concludes that many developments have benefited fund managers rather than investors.

Although on a much smaller scale, the NZ managed fund sector shares many of the characteristics of the US industry thus Bogle's comments have relevance for NZ retail investors, particularly now as the industry looks forward to a material increase in funds under management.

First off, Bogle notes that, in 1945, the managed fund industry was comprised mainly of highly diversified, blue-chip oriented, middle-of-the-road share funds. Today, barely 10 per cent of the industry's 4200 stock funds are widely diversified with most having a specialised country or sector focus.

Now choosing the right fund takes as much skill as picking a portfolio of stocks. Indeed, many investors now own portfolios of funds rather than 1945's portfolio of stocks.

So what is the point of such specialisation? It's not for the benefit of investors, that's apparent. Instead, it is driven by marketing departments scrambling to increase funds under management by catering for the latest craze - remember the flurry of technology funds in 2000.

Great for business but it defeats the number one attraction of a fund - diversity. Not only does specialisation make picking a fund more difficult, it increases the risk of a bad result as it permits investors to speculate by buying the flavour of the month. It also drives up costs.

Bogle also disparages the emphasis on short-term performance. He notes that portfolio turnover - the rate at which a managed fund buys or sells stocks in their portfolio - has soared.

Back in 1945, shares were held by a fund for an average of six years; today that is down to only 11 months.

Bogle notes that managed funds, once stock owners, have become stock traders, moving further away from what the world's most successful investor, Warren Buffett, describes as his ideal holding period - forever. Turnover of stocks and bonds by US managed funds comprises about US$8 trillion a year. That's a lot of brokerage.

Similarly, the average time which unit trust investors hold their managed funds has also plummeted from an average of 16 years in 1955 to four years in 2004.

In NZ, switching one unit trust for another underlies the monitoring process provided by financial planners. Free switching, however, is an illusion created by fund managers and financial advisers. The real cost of these transactions is huge but is hidden from most investors in that the fund, all unit holders, pay the transaction costs.

While promoted as free switching, the reality is that substantial costs are incurred, costs that you probably didn't need to pay if you had owned a diversified fund in the first place.

Now, to the cost of fund ownership. Bogle estimates that annual fees have risen by 100 per cent between 1945 to 2003, from 0.8 per cent pa to 1.6 per cent pa. There has been none of the reduction in fees that one could expect from economies of scale despite assets under management having risen by 3600 times.

Bogle notes that the major trends in the US managed funds sector have been to produce more and more specialist funds, emphasising short-term performance time horizons, held by investors for shorter time periods, with a focus on asset gathering and marketing. What's more, all this is costing a lot more than it did in 1945.

But what if we accept what our fund manager of the year would have us believe - fees aren't important, it's the return to the investor that is critical? So how then has the US managed fund sector performed over the long term? Bogle compares the average return of the US sharemarket in the periods 1945-1965 and 1983-2003 with the average equity fund return in the table.

Bogle asserts that the widening gap between the market return and the fund return is due to costs, which have increased markedly in the past 50 years.

He concludes managed share funds are commodities that are differentiated largely by their costs. After all, with fund managers competing among themselves in picking stocks, average fund returns must inevitably parallel those of the equity market itself and thus fall short of those returns by the amount of their management, marketing and turnover costs.

* Brent Sheather is a Whakatane-based financial adviser.