The illusion of focusing on financial services fees

The focus on fees levels in financial services and investment risks missing the structural flaws and distorting incentives that are also troubling these industries, writes Dominic McCormick.

At a recent Association of Superannuation Funds of Australia (ASFA) speech, the outgoing Australian Securities and Investments Commission (ASIC) deputy chairman Jeremy Cooper and chairman of the upcoming superannuation review startled the audience by beginning his speech by saying that all superannuation fees would be banned.

He was joking of course, but by the end of the speech I wasn’t so sure.

Cooper went through virtually every fee in the investment management and financial services industry, pointing out concerns and stating they were up for review.

What ‘review’ really means is unclear but one was left with no doubt that there is likely to be increased regulation around, and control of, fee levels in the superannuation area at least.

Fees are clearly an important issue in the context of a financial services and investment industry that has disappointed investors in recent years.

And given the tax incentives provided to superannuation, concern that balances aren’t eroded by excessive fees is understandable.

While there is a worthwhile debate to be had about how lower fee outcomes are delivered, this is unfortunately being swamped by the obsession with the number and level of fees alone, no doubt assisted by the regulators’ focus and the ongoing campaign by industry funds on commission and costs.

This focus, directly and almost exclusively on fees and fee levels is, in my view, dangerous because:

• it risks neglecting, or at least de-emphasizing, the structural flaws and distorting incentives that exist in the financial services/investment industry and that can lead to poor outcomes for investors (including, but certainly not limited to, excessive or poorly structured fees); and
• it reinforces the growing (and in my view false) mantra that the level of fees is the all important (and for some it seems only) variable determining long-term investment returns. Fees are not the only factor that can erode investment returns; poorly performing financial markets and poorly structured investments and investment portfolios can be much more destructive, even over the long term.

I will address these two points in more detail below.

Rather than attacking all fees with a hammer, wouldn’t it make sense to focus first on the flawed incentives and structural weaknesses in the industry that have contributed to poor outcomes for investors or that create perceptions among investors that they could be delivered poor outcomes?

Under a regime where major structural flaws were removed — and with adequate and simple disclosure — you would expect the market to do a reasonable job of determining the actual level of fees. (It is clear that disclosure alone has not worked).

These structural flaws around incentives are numerous and I don’t need to go through them all in detail.

However, the key guiding principle should be that payments relating to investment and investment services, in the vast majority of cases, should be explicitly made by the clients receiving the service to the service provider, with any rebates or fee reductions negotiated by intermediaries only used to directly benefit their clients.

The current approach where many in the financial services industry rely on other participants in the industry to develop fee structures/levels and collect fees from their clients would largely disappear.

Commissions on products and loans are the obvious such arrangement attracting enormous discussion and proposed actions now.

But then there are various fund management rebates to dealer groups and platforms that are not passed through to the actual investor.

Fund managers paying for research ratings that are primarily used by advisers is another flawed incentive structure that may be restricting the quality of research provided to those advisers.

Other structural flaws relating to incentives could also be addressed. For example, the payment of fees on gross rather than net assets can encourage excessive gearing. Performance fees without high watermarks or suitable hurdles also raise questions.

The other guiding principle should be better alignment of the interest of providers of, or those recommending, investments with their investors.

The former should clearly be able to be well rewarded over time, but ideally over similar time horizons as that of their investment product or portfolio.

Situations where product providers and distributors receive significant up-front payments for (mainly) structured products that run for five to 10 years are clearly flawed.

This might sound a bit idealistic, particularly in an industry where all participants (including ourselves) have to make decisions and act under the current rules of the game.

But wouldn’t it be much better to get these structural elements right before resorting to specifically regulating or limiting the level of fees alone? Wouldn’t the market do a better job of setting the fees once these flawed incentives were removed or improved and disclosure simplified?

Cooper also suggested that there are really only two variables affecting returns to investors: good long-term investing and the level of fees.

The problem is “good long-term investing” is not a given and there is no perfect and simple recipe for it. The implication is that low fee, passive portfolios might be the answer for many investors.

Perhaps investors should have more money managed passively. It certainly would have enabled the avoidance of some of the worst product failures of recent years.

However, while the passive approach will deliver investors market returns (less costs) there are no guarantees that these market returns will actually meet investors’ risk and return objectives, even over the long term.

Just look at Japan and the US for examples where equities have produced negative returns over 10 years or more.

Is there the same level of focus and extensive review of fees in these countries, especially the US? It does not seem to be the case.

While the regulatory environments differ, perhaps this differing focus is more because a conventional, growth portfolio highly weighted in equities has lost money over the past decade whether investors paid high fees or low fees.

Perhaps it’s because one or two intelligent moves such as avoiding the tech wreck or cutting back equities in 2007 would have had much more impact on long-term returns than reducing fees by 10, 25 or 50 basis points per annum over the period.

Clearly, fees are not the only, or even a significant factor in investment returns for some investors and through certain time periods.

It’s a topic for another article but there is no pre-determined, fixed asset allocation, passive portfolio that is certain to meet investors’ objectives even over the long term, even at zero fee levels. Markets can go down or sideways for extended periods.

There is no simple prescription for good long-term investing that always works. Good investing needs to be dynamic, and good investors focus on after-fee returns.

In the US, for example, the major debates currently are not over fee levels but over more fundamental investing questions, such as ‘are markets really rational’ and ‘is buy and hold dead’, ‘what are the flaws in Modern Portfolio

Theory’, and ‘what is the role of alternatives in investment portfolios and lifecycle investing’. In Australia we risk neglecting these more fundamental investment debates if all we do is endlessly debate fee levels.

It is worth noting that the original impetus for the growth of passive investing was not so much due to a focus on lowering fees, but rather because of the growing belief in the efficient market hypothesis in the 1960s and 1970s, where prices were meant to reflect all available information, so the identification of overvalued or undervalued securities (or asset classes) was impossible.

Increasingly, it has become obvious that this view of the world is flawed. Financial markets are often inefficient, subject to ‘fat tails’ and prone to bubbles and busts.

Of course, markets are still difficult to beat and passive investing can still have a role in many portfolios, but the view that passive investing should automatically earn the mantle as the basis for ‘good long-term investing’ is questionable, to say the least.

(For an excellent description of the evolving view on the efficient markets theory in the past half century or so see the recently published The Myth of the Rational Market by Justin Fox).

Ultimately, it is after-fee performance that matters to investors. Some managers, strategies and assets justify higher than passive fees with better returns, lower risk or diversification benefits.

Of course, identifying these in advance and managing them in a portfolio on an ongoing basis is not easy.

The local obsession with fees is against a background where, even despite the severe setback in markets recently, the experience of most Australian investors through the past two decades has been quite positive.

Simply having a near passive, long-term portfolio across most asset classes produced good returns.

Against this benign long-term background, it is not surprising recent problems have sparked a focus on fees as an easy scapegoat.

However, this focus on fees runs the risk of diverting attention from much needed debates on investment philosophy, strategy and building sensible portfolios.

Of course, the past couple of years have been very tough for many investors and especially those with a significant exposure to failed products such as Basis, WestPoint, and MFS Premium Income, and so on.

Other product categories have also disappointed and aggressive gearing has destroyed many investors. But would portfolios heavily weighted to these products/strategies really have done much better simply if they had lower fees (focusing on ongoing not upfront fees here)?

Much more important is to focus on the incentives that encourage the existence, recommendation and high weighting of flawed products/strategies in the first place and to encourage the application of sufficient and appropriate resources to avoid such outcomes in portfolios.

On a related matter, ASIC recently proposed an investor awareness campaign that would divide investments into those “between the flags” and those “outside the flags”.

“Safe products” such as bank deposits, superannuation, blue chip shares, and “vanilla” managed funds would be classified as between the flags.

More complex, illiquid, undiversified or leveraged products, debentures and mortgage trusts would be deemed outside the flags and implicitly not safe.

This is again oversimplifying a complex world in ways that could actually discourage investors from maintaining well diversified and robust investment portfolios that often include exposure to more complex investments that would be seen as risky or complex from a stand-alone perspective.

Meanwhile, some vanilla managed funds that will likely be classified between the flags still managed to fall more than 50 per cent last year.

Like the rushed decision to ban covered short selling (which the regulator has since lifted) it seems we are reaching the point where the regulators feel it is their role to direct where investors invest and decide what good investing is about.

These are the same regulators that missed virtually all of the blowups of the past few years.

In contrast, large parts of the active investment industry (especially those participants not subject to major conflicts of interest) have done a reasonable job of avoiding most of these product and strategy disasters.

However, with increasing competition and looming fee pressure, the ability to focus resources on this task may be hampered.

Let’s face it. Investing at times is complex. Dumbing it down is not the answer. Instead this might just preclude access to well diversified portfolios that can increase investors’ returns and decrease risks.

Financial services participants that can help investors manage this complexity well and meet their objectives over time should be able to be well rewarded.

Fees certainly can’t be ignored and the fundamental incentives need to be structured correctly.

But without being assessed in the right framework there is a risk of dumbing down the Australian investment management and financial services industry that will leave it poorly positioned to meet the challenges investors will face in the future.

A relatively free (but properly incentivised) market for financial services is vital to maintain a dynamic and motivated industry that continues to focus on sensible investment solutions for its clients.

The downturn and competitive pressures are already resulting in downward pressure on fees in many areas.

Let’s hope the industry’s incentive to provide sensible solutions for investors is not hindered in an already tough environment by a blinkered attempt by regulators and government to control fees.

Markets certainly aren’t perfect or always rational, but like the capitalist system itself, in the words of Winston Churchill, “It’s the worst system apart from all the others”.

The pendulum of deregulation almost certainly swung too far, but the risk is we now swing back too far in the other direction, or at least with the wrong types of regulation.

While focusing more on the macro economy, Chris Corrigan recently summed up some of the risks of excessive regulation well, as quoted in BRW.

“… If governments knew better than … markets, we would see more examples of centrally planned economic success. There are none. We are now entering an era of ‘government knows best’ and we will just have to find out the hard way in lost growth, jobs and living standards.”

There is still hope that the regulators tread cautiously.

Dominic McCormick is the chief investment officer at Select Asset Management.