Fund Charges and Transaction Costs

In 2015-2017, the FCA reviewed and consulted on the asset management industry and one of its key recommendations was greater clarity on charges. Chris Sier was appointed to make recommendations on how this should be done. His focus was on pension funds and the costs they incurred from their fund managers. Today, I saw a LinkedIn post by Chris, which I found illuminating and contains links to two further articles, for those who are interested in this area. Chris, who was commenting on a pensionsage.com EXCLUSIVE: “Transaction costs make up 37% of pension investment costs”, said:

“The truth is complex:

1. Sample size – for such statements to be robust, a large sample size is needed and must be stated;
2. % of transaction costs (TX costs) in a portfolio varies according to asset class (https://www.pensions-expert.com/Investment/If-you-think-you-know-your-costs-you-could-be-wrong-UPDATED). Therefore at pension scheme level, % of total TX costs for a scheme varies according to asset allocation & asset allocation varies according to scheme size (https://www.pensions-expert.com/Investment/Asset-allocation-analysis-reveals-UK-s-governance-weakness);
3. % of TX costs increases the higher the initial manager cost for active equity. Bluntly, the % of TX costs at portfolio level varies according to size of mandate and to the initial management fee, which is truly remarkable.
4. TX costs vary according to Seg v Pooled structure, which varies with scheme size (Pensions Expert article for Monday).
5. I have the mean TCO of a DB scheme in the UK at 59bps (sample size ~250 schemes but it varies according to size of scheme…in other words it’s a mix of asset allocation, mandate size, scheme size and seg v pooled mix. So “70bps” is not the answer.”

Retail investors

Platforms and Fund Managers have not rushed to produce simple, easily understood and comprehensive explanations of costs. Regulators have specified KIDs which have various problems and cost disclosure documents. But too often these show strange numbers and I don’t trust them as helpful. Much could be done to make the life of the retail investor easier, in my opinion.

Background links and historical documents

See https://www.sharesoc.org/sharesoc-news/response-to-fca-cp19-12-consultation-on-investment-platforms-market-study-remedies/

The 2019 FCA consultation document is here https://fca.org.uk/publication/consultation/cp19-12.pdf

The 2019 consultation was a result of a 2017 FCA consultation https://www.fca.org.uk/publication/market-studies/ms17-1-1.pdf

This consultation, in turn, was a result of the outcome of the 2016 consultation into the asset management industry, which produced the interim 2016 FCA report which was highly critical of the asset management industry – it is available here: https://www.fca.org.uk/publication/market-studies/ms15-2-2-interim-report.pdf .

The 2017 FCA final report https://www.fca.org.uk/publication/market-studies/ms15-2-3.pdf, was slightly less damning, and below are its key findings (The bold text are parts highlighted by me):

Final findings

We find weak price competition in a number of areas of the asset management industry. Firms do not typically compete on price, particularly for retail active asset management services. We carried out additional work on the pricing of segregated mandates which are typically sold to larger institutional investors. This showed that prices tend to fall as the size of the mandate increases. These lower prices do not seem to be available for equivalently sized retail funds.

We confirm our interim finding that there is considerable price clustering on the asset management charge for retail funds, and active charges have remained broadly stable over the last 10 years. We agree with respondents who said that, in and of themselves, price clustering and broadly stable prices do not necessarily mean that prices are above their competitive level. However, we also found high levels of profitability, with average profit margins of 36% for the firms we sampled. Firms’ own evidence to us also suggested they do not typically lower prices to win new business. These factors combined indicate that price competition is not working as effectively as it could be.

Performance

We looked at fund performance, and the relationship between price and performance. In our additional analysis, we found substantial variation in performance, both across asset classes and within them. However, our evidence suggests that, on average, both actively managed and passively managed funds did not outperform their own benchmarks after fees. This finding applies for both retail and institutional investors.

We looked at whether some investors, when choosing between active funds may choose to invest in funds with higher charges in the expectation of achieving higher future returns. However, our additional analysis suggests that there is no clear relationship between charges and the gross performance of retail active funds in the UK. There is some evidence of a negative relationship between net returns and charges. This suggests that when choosing between active funds investors paying higher prices for funds, on average, achieve worse performance. Similar academic studies of the US mutual fund industry have typically found a negative relationship between fund charges and fund performance.

It is widely accepted that past performance is not a good guide to future performance. We find that it is difficult for investors to identify outperforming funds. This is in part because it is often difficult for investors to interpret and compare past performance information. Even if investors are able to identify funds that have performed well in the past, this past performance is not likely to be a good indicator of future performance. There is little evidence of persistence in outperformance in academic literature, and where performance persistence has been identified, it is persistently poor performance.

1.14 We found some evidence of persistent poor performance of funds. However, we also noted that worse performing funds were more likely to be closed or merged into better performing funds. In our additional work, we found that the performance of the merging poorer performing funds improves after they have been merged. However, we also found that the performance of the recipient fund, on average, deteriorates slightly after the merger, although it is not clear that this is a direct result of the merger. While mergers and closures may improve outcomes for some investors, not all persistently poorer performing funds are merged or closed. It can also take a long time for worse performing funds to be closed or merged.

Clarity of objectives and charges

1.15 We have concerns about how asset managers communicate their objectives to clients, in particular how useful they are for retail investors. We find that many active funds offer similar exposure to passive funds, but some charge significantly more for this. We estimate that there is around £109bn in ‘active’ funds that closely mirror the market which are significantly more expensive than passive funds.

1.16 We consider value for money for asset management products typically to be some form of risk-adjusted net return. This can be broken down into performance achieved, the risk taken on to achieve it and the price paid for the investment management services. Investors’ awareness and focus on charges is mixed and often poor. There are a significant number of retail investors who are not aware they are paying charges for their asset management services. However, we have found that many institutional investors and some retail investors are increasingly focused on charges.

Investment consulting and other intermediaries

1.17 We find significant differences in both the behaviour and outcomes of different institutional investors. A number of, typically, large institutional investors are able to negotiate very effectively and get good value for money. However, we also see a long tail of smaller institutional investors, typically pension funds, who find it harder to negotiate with asset managers. These clients generally rely more on investment consultants when making decisions.

1.18  We have identified concerns in the investment consulting market. These include the relatively high and stable market shares for the three largest providers, a weak demand side, relatively low switching levels and conflicts of interest.

1.19  More generally, we recognise that asset managers play a role alongside others in the chain that delivers investment products to consumers. Our analysis suggests that retail investors do not appear to benefit from economies of scale when pooling their money together through direct – to – consumer platforms. We also have concerns about the value retail intermediaries provide.

Package of remedies

1.20  The feedback we received from respondents helped us refine our thinking about how to address the concerns we identified. As a result, we are proposing an overall package of remedies to make competition work better in this market, and protect those least able to actively engage with their asset manager. We consider that this will increase efficiency, lead to the UK asset management industry being a more attractive place for investors and so improve the relative competitiveness of the UK market.

Our overall package of remedies is designed to bring together a consistent and coherent framework of interventions. We recognise that some investors are not well placed to find better value. Because of this, we are strengthening the duty on asset managers to act in the best interests of investors and are seeking to provide greater protection for investors. The remedies package also seeks to enable those investors who are able to, to exert greater competitive pressure on asset managers. It will increase the transparency of costs so that those seeking information can get it. We are also working towards providing greater clarity of fund objectives and performance reporting. Finally, the package seeks to improve how effective intermediaries are for both retail and institutional investors.

Cliff Weight, Director, ShareSoc