Bear markets put the squeeze on fees

We are all aware that reduced levels of investment returns will lead to more clients demanding lower overall fees for their managed investments.

For many fund managers, this will be exacerbated by the extent of fee shifting between the various components of the managed investments’ ongoing total management charges.

Marketing 101 for Dummiespresents a value chain for the consumer (see diagram).

In the next few years, the big issue will be the shifts in the relative slices of the pie received by each of the four groups.

While each player will be seeking to increase their own share of the pie, I suspect that not too many have thought about having to defend it — or the consequences if market forces result in their share diminishing.

Driving forces

Dealer groups and financialplanners

At present, dealer groups receive trail commissions from managed investments, together with any dial-up additional fees debited from the investor’s account. The dealer group then pays the financial planner a share of the total ongoing fees, typically around 80 per cent of trail commissions and any additional fees charged by the financial planner.

Trail commissions vary between 0.3 per cent and 0.6 per cent per annum. More complex products, such as master trusts and wrap accounts will allow the planner to dial up an additional 0.5 per annum to 1.0 per cent as an additional trail commission.

For this, the financial planner provides the following services, in sequential order:

n needs analysis;

n risk profile;

n optimal tax structure;

n fund manager selection;

n regular reviews; and

n a sounding board during downturns.

If you asked the average client to rank these services in normal times (ie. not in a bear market), with the first representing the most important, it would probably look something like this:

n fund manager selection;

n optimal tax structure;

n needs analysis;

n risk profile;

n regular reviews; and

n a sounding board during downturns.

In bear markets, many clients panic, sell at the bottom, and sack their financial planner for investing them in growth assets.

While these are very general observations, they are based on the belief that clients think that picking investments (or investment managers) and minimising tax are the most important things.

I personally believe that the most important ongoing role of a financial planner is to hold the client’s hand when the going gets tough, and prevent the client from selling their growth investments at the bottom of the cycle.

History shows that retail clients direct funds towards equity investments at the top of the share market cycle, and away from equity investments at the bottom of the cycle.

The most important thing a planner can do therefore, is to reverse this historic trend. Unfortunately, most clients are driven by greed and fear and it is often beyond the skills of anyone to prevent a significant proportion of clients from buying at the top and selling at the bottom.

Because of this, a significant proportion of clients will not value this service, and accordingly, will not pay for it.

I can’t envisage what will allow financial planners to increase their share of the pie. However, there are a number of factors that may, in the longer term, put downwards pressure on their share.

Lower longer term nominal and real rates of return is one.

Another is that there can be a perception, often unwarranted, that because selected portfolio managers have produced negative 12 month returns, the financial planner has lost the client’s money, and is therefore a failure. Even though the client believes they can handle negative returns at some future date, the reality is often different. Because the client perceives that the planner is a failure, any level of fees is hard to justify.

The final factor is that most planners are realising that picking investment managers is a very difficult game. As they step away from this part of the planning process, often by utilising multi-manager sector specialist portfolios, they stop doing the very thing that their clients (often incorrectly) perceive is the highest value-add of the financial planning process.

Platform or product owner

There are two main sorts of products that are sold to clients. If you leave aside the historical single investment manager product, the two generic product options are:

n Products without a cash trading account, that offer a more limited number of investment options. These investment options can be categorised as:

— house brand investment portfolios;

— external brand investment portfolios; and

— multi-manager sector specialist portfolios.

Examples include theING‘OneAnswer’ product range, and theColonial First State‘First Choice’ product range.

n Products with a cash trading account that offer a greater number of investment options. These investment options can be grouped in the same manner as above.

Examples include the SealcorpAsgardMaster Trust range of products, and theAXASummit Master Trust range of products.

At present, these two styles of products are sold by most financial planners, with a preferred range of master trust(s) being used by each dealer group.

Product/master trust fees range from around 0.7 per cent to 1.5 per cent per annum, depending on the size of the client balance, and the nature of the master trust. These fees exclude wholesale investment management fees, and trail commissions.

Many commentators, including Cerulli Associates, believe that there will be about five major platforms for master trusts/wrap accounts in Australia in five years time. This rationalisation will be primarily driven by the high level of ongoing technology development required by these products.

Efficient master trusts currently have costs of the order of 0.4 per cent to 0.5 per cent per annum. If you add a 0.25 per cent per annum profit margin, then master trust platform fees should trend down towards 0.7 per cent per annum.

With consolidation, and the emergence of smarter technology, I can envisage a scenario where you will be able to obtain a ‘white label’ product for around 0.5 per cent per annum. Platforms will have become commodities. However, it will take time. This will result in a smaller share of the pie for the platform providers.

Wholesale investmentmanufacture

Wholesale investment manufacturers have seen their fees come under significant pressure in recent years.

One reason is that investment manufacturers have been giving significant discounts for volume. These discounts may have been appropriate for corporate super funds, but are not appropriate for master funds. I have seen instances of marginal fees for Australian equity portfolios falling to 0.2 per cent per annum for portfolios in excess of $1 billion.

Further, master funds and distributors have captured the client and demanded big discounts from manufacturers. These discounts have then been used to subsidise master trust administration fees in many cases.

And investment manufacturers are also falling victim to master trusts and distributors in the same manner as the life offices allowed the transfer of profits to the industry superannuation funds in the early 1990s with excessive crediting rates.

Wholesale business development managers, meanwhile, are generally remunerated on sales, not profit on sales — shades of the old mutual life offices.

However, the investment manufacturer is the sizzle that clients buy. All the current big brands originally built their brand from investment performance —BT, Colonial First State,Perpetual,Credit Suisse. A number of boutiques such as Alpha and Constellation Capital are currently delivering very good performance.

Active Australian equity portfolio management generally suffers from the law of diminishing returns once portfolios exceed $10 billion. Why give your value away for low fees?

In five years time, I predict the slice of action held by wholesale investment manufacturers will significantly increase, albeit from a smaller pie.

Peter Worcester is a consultant tothe funds management industry.