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The opportunity cost of low fee structures

Beware the investor who knows the price of everything but the value of nothing. Fees are obviously important, but managers should ultimately be evaluated based on their ability to add net and real value to a portfolio.

The fees and costs associated with fund management and superannuation have rightly become an important concern for investors. It is natural that all investors want to acquire the ‘best’ possible investment option at the lowest possible cost. Particularly in today’s world of sustained low cost of capital, maximising net income and returns are hugely important.

Focus on net returns, not only costs

In the ongoing debate surrounding fees, too many investors are putting the cart before the horse. Common sense dictates that when comparing fund manager performance, the logical metric on which to focus is net return after fees and taxes. But by approaching investment strategy with a ‘fee budget’, investors are eliminating from consideration the very investments that might help them achieve higher net returns.

By way of disclosure, I joined an industry super fund close to its launch, and continue to have all of my super managed by the same fund. So I am raising this issue as a member of the industry fund structure. To paraphrase Peter Drucker, that which gets measured gets managed. Wearing my other hat as a principal of a major fund manager, my bias is towards metrics directed at diversifiable, sustainable and net returns, after fees and taxes.

There are of course other costs associated with superannuation, such as custody and administration, to name but two, and we should not confuse these separate issues. To be clear, my comments here are squarely focused on management fees charged by product providers.

The broad conversation on the fees and costs associated with our industry is healthy and welcome. It is particularly positive given the likelihood that future costs of capital, and ultimately asset class gross returns, will likely be noticeably lower than yesteryear’s ‘CPI++’ asset class medium-term returns. Today, even the most optimistic forecaster is struggling to suggest any normalised gross returns above CPI. And if we add health care as yet another future expense needed to be immunised, a likely benign real cost of capital environment proves even more problematic for investors.

My concern, nonetheless, is that as the long term cost of capital and asset class returns remain benign, almost by definition the need to break away from benchmark returns will increase. By committing to a more rigid fee budget, perhaps a consequence is the inability to access a more diverse and less benchmark-aware product pool.

To make matters worse, it appears as though within this low return world comes increased market volatility and uncertainty. In my view, we have migrated from a world of market ‘volatility’ to one of ‘uncertainty’. Whereas volatility can be quantified, market risk and expected returns are becoming all too difficult to quantify. Looking at historical data from similar periods of prolonged market instability – the US in the 1970s and Japan in the 1990s – may give a sense of what this may mean to investors. During these periods, these market indices were ranked fourth quartile within market league tables, even on a net of fee basis.

Closer to home, if one looks at benchmark-agnostic Australian equity funds with truly long term track records, they surely wouldn’t exist were they unable to deliver net returns above benchmark. In the Mercer Universe of long-only Australian equity managers over a ten-year period, the median manager has outperformed the index on a net of fees basis. This should appeal to the average fund member. There is also a common misconception that active funds are more volatile than the broad benchmark. It’s the benchmark which has shown larger increases in volatility, at least more so than the active manager’s net returns.

SMSF asset allocation

Ironically, while fees impact all members and superannuants, the focus of the debate has been more pronounced and visible within institutional and industry super funds. We have seen a growing army of individuals opting-out of well-diversified industry and retail funds in favour of their own SMSF. The size and depth behind this growth continues to astound me.

According to recent ATO statistics, the SMSF asset pool is heavily skewed towards cash and term deposits. Even under normal circumstances, let alone within this low return environment, this asset class is least able to fund retirees. When one considers that administration and charges associated with running an SMSF often exceed their gross nominal cash or term yield, how ‘safe’ is cash when immunising future pension income?

Any share allocation which may exist is often directed to a mere handful of blue chip Australian names, and almost zero allocation to offshore investments. In the cases where SMSFs do access actively managed Australian equity funds, it’s often through Listed Investment Companies (LICs) where, ironically, management fees and entry charges (the cost of an IPO, for example) can be prohibitive.

Many SMSF holders do not appear to appreciate the extent of the choice and level of control that industry or retail fund members already have in selecting investments. It is individuals’ desire for control, combined with a blind spot to the actual costs of establishing and running their SMSF, which has helped fuel the SMSF behemoth.

So we now have a situation where some institutions appear overzealous within their fee budgeting, while at the same time, many individuals almost disregard fees and charges within the continually growing SMSF sector.

Preoccupation with lowest fee options

This focus on fees needs moderation and greater debate. Moving towards the lowest fee option may only lock in broad market volatility. Equally, seeking one’s independence can often be the highest fee option. Either way, my fear is that some will confuse price with value, or more specifically, with value-add.

Fees do matter, but they don’t matter more than sustainable net total returns (net of fees, taxes, and of course, inflation). It is important to remember that in the long run, the lowest fee option can have the highest opportunity cost.

Rob Prugue is Senior Managing Director and Chief Executive Officer at Lazard Asset Management (Asia Pacific). His views are general in nature and readers should seek their own professional advice before making any financial decisions. 

6 Comments
Graham Wright
January 30, 2015

I think Rob's last paragraph says it all. At the end of the day, I am concerned with how much income I have to pay all of my expenses and fund my living. If I need to pay higher fees or premiums to have a manager outperform my own capabilities, it means more spending money for me. If a manager gets richer at my expense, I am getting richer because of their better performance. I just do not want to pay more for a manager who cannot outperform myself.

I currently have a SMSF and rely heavily on LICs in the current environment and find that without luck or risk on my part, they outperform me. Now I am exploring the idea of managed funds or a commercial Superannuation Fund Instead of continuing with the hassle and responsibilities of the SMSF. A high performing fund with a manager demanding a premium for his/her skills is surely woth more tban average performance with attendant hassles and responsibilities.

Rob Prugue
February 04, 2015

Hi Graham;

Thanks for your comments. Always welcome, be they positive or constructive. Nonetheless, you raise an interesting point re LIC. While I have nothing against them, there is an additional fee/cost to consider here. LICs can prove to be costly, and their correlation can move given they often trade at discount to the NAV. So while I am not speaking against, nor would I endorse them until this cost is added to the assessment process. If a manager is targeting an alpha of say 3 to 5%, with a tracking error of 5 to 7%, I would suggest this vehicle cost is added in the netting of returns and its analysis.

In the meantime, thank you again for your input.

Happy hunting
Rob

Jerome Lander
January 30, 2015

As Rob alludes to performance relates to performance after fees and costs vs the risk taken. An index can be a very risky investment contrary to popular belief and may indeed be an extremely imprudent investment. Contrary to popular opinion, an active manager or strategy can be less risky than an index. For example, a good long/short fund should have less downside risk and less risk of loss of capital than an index.

Large institutional funds have the money to find good active managers (but sometimes lack the expertise, know-how or will). They often underplay the importance of active management as that is currently in-vogue.

Individuals will surely need to be aligned with the right type of help, and unfortunately this is all too rare. Where they can get it, they can do very well indeed.

So much as people may love to generalise, it is indeed an individual assessment that needs to be made and adopted. It really all depends upon simply aligning yourself with the right expertise.

Adele Watson
January 30, 2015

Spot on!

Donald Hellyer
January 30, 2015

Perhaps for an individual the decision is too hard to select active management. There are two hurdles for an individual. First you have to believe active management will out perform the index, and despite the Mercer numbers the evidence on this is not convincing. If anything it suggests active managers don't out perform. Secondly, even if we accept there is excess return from active managers, we face the bigger barrier that how does an individual know who is a good manager and who is a poor manager. The search cost here is too high for an individual I would suggest it is also too high for Superannuation Trustees to comprehend.

Active managers should not beat the benchmark after fees. The hurdle should be beating the benchmark by at least 2x fees.

Rob Prugue
February 04, 2015

Hello Donald;

No surprise here, inasmuch having an active manager sing from his own hymn book. But as long argued, even from my asset consulting days, there is NO such thing as a "passive" investment. The only undeniable fact is that passive funds are cheaper than active funds.

My own fund (please excuse this self promotion), has beaten the ASX 200 by 500 bps over the past 5 years. Regardless, often these relative return series can fluctuate depending on the time period. What I would suggest, is that this is often a reflection of macro economic conditions as wild fluctuations favours the active manager (buy low, sell high). When market rises rapidly, or is in a secular bull market, most active managers struggle.

Also, please have a look at the ETF access of index funds. They don't always correlate perfectly, even pre or post fees. In particular, look at emerging market equity ETF, and compare these results to the index. The results may surprise you.

Either way, thank you for your considered response. Hope this note finds you well.

Kind regards
Rob

 

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