Observer: Is the investment fee debate rational?

With the poor performance of superannuation and managed funds dominating the media in recent months, investors are being encouraged to seek the lowest cost investment solutions and managers. But is this really the right answer?

A 10, 25, 50 or even 100 basis points reduction in fees would not have made the negative returns of the last two years positive. Note here that I am talking about ‘investment management’ fees only. While I am definitely a believer in investment performance fees, this is the subject for another discussion.

There is no question that there are plenty of mediocre fund managers earning excessive management fees and that, all other things being equal, investors should prefer and seek lower investment management fees.

Unfortunately, all other things are almost never equal and I question whether an overwhelming focus on achieving the lowest investment management fees is entirely rational.

I believe the level of investment fees should usually be a relatively small factor in investment decision making. However, one can only have a rational view on management fees once they have developed their own clear view on how investment markets actually operate, and particularly how they operate for them given their size and circumstances.

If you believe that markets are efficient, that active management doesn’t add value and that all active investment management should be considered a ‘commodity’, then the emphasis on minimising investment management costs is totally justified.

Alternatively, those deploying very large amounts of funds are often so constrained that it can make sense for them to view the world in this way.

In such a world, life becomes very simple — invest broadly across markets in index/passive funds at the lowest cost available. Today there are plenty of passive options available and it is not surprising that true believers in index funds, such as Vanguard’s founder John Bogle, push the low cost argument so aggressively.

On the other hand, if you believe (as I do) that markets can sometimes be very inefficient, that some of these assets and strategies are more difficult to access, that good active managers can add value and that such managers can be identified in advance, then this argument and approach is flawed, particularly for those investors not constrained by size. In this world, better active investment solutions than others are available. Some are worth paying higher fees for.

In such a world, the idea that there is a specific ‘fair price’ for investment management of an active Australian equity fund, for example, is clearly flawed. People are willing to pay more for a better car, better clothes, better food — why not better investment management?

How much more? It is hard to say but, if you were confident a particular manager could earn even 1 to 2 per cent per annum higher than average, then paying an extra 10, 25, 50 basis points or even more for this is entirely rational. Alternatively, sometimes returns are expected to be no higher, but risk is lower and this may also be worth paying more for.

Discerning who is a good fund manager (and importantly who can continue to be) is not easy. Simply looking at historical performance is obviously not the answer. The important thing is prospective returns and risks.

I do believe there are factors that help to identify those managers likely to outperform in the future. One thing is clear — if you play in the active management pool but use only those offering the lowest price, you are likely to be disappointed.

This fee discussion has become vitally important today, as many new multi-manager ‘fund of funds’ and model portfolios are being structured, seemingly with the major objective of achieving a low management expense ratio (MER).

Some of the more recently offered configurations have been including as much as two-thirds of the portfolios in index or enhanced indexed components to achieve this. The introduction of new low cost index options such as Macquarie True Index funds with no explicit fees has helped facilitate this.

While some groups structuring funds in this way are doing so because they believe in passive management, the pressure to be seen to offer a low headline cost suggests some are being driven heavily by a business, not investment, perspective.

This problem has become more pronounced as platform providers with an asset gathering and marketing focus have become the main drivers of such products. Where an outside investment party such as an asset consultant is employed to help, they are often under strict instructions to achieve a target MER or to use a certain percentage of lower cost in-house products.

In my view, the idea of targeting a specific MER for a multi-manager, multi-asset portfolio is ludicrous. That said, I am glad much of the industry constructs portfolios this way — it means they are being distracted from creating better portfolios and from some of the best managers.

The total investment costs in a fund of funds/model portfolio should be an outcome of the investment process, not a predetermined driving factor for portfolio construction.

Investment fee disclosure is often looked at far too simplistically. People are constantly looking for one simple number that describes the cost of the management of the assets they are invested in. But does it really exist?

Fund of hedge funds are often criticised for not fully detailing the underlying fees on the managers they invest in. However, perhaps Australian equity fund managers should also be disclosing the management costs of the companies they invest in? Where would it all end and even if it could be done sensibly, would it have any meaning to investors?

Investment fees should be disclosed to and understood by people who can assess their value. It creates more problems than it solves to provide more and more information on fees, leaving investors and planners to make decisions based heavily on these fees alone.

The next time someone argues that investment management fees should be controlled or that they expect all Australian equity mangers fees to be the same, realise that they are saying that they believe markets are efficient, or at least that no one can select a better manager in advance.

I have nothing against those who believe in efficient markets and indeed passive management may well be the best answer for many investors, including the largest investors who can not easily take advantage of inefficiencies. It is certainly a better answer than chasing the latest best performing asset or popular manager.

However, believers in this ‘low cost’ investment world should recognise that it already exists. It is the world of passive/index investments. As such they should refrain from enforcing their own views on the rest of the investment management industry world who (rightly or wrongly) believe in active management and therefore (should) believe in paying more for a better fund.

By incessantly babbling on about costs being the only factor to consider, they are forgetting that outside the commodity world of passive and ‘pretend active’ management, value for price is what matters, not just price.