How much do you pay for your free lunch?
Diversification benefit is often described as the only free lunch in investing. But not if fees eat half of it right in front of your eyes!
Our industry is becoming increasingly cost aware. Wherever you turn up, sooner or later you will find yourself discussing AMCs,
The list is only getting longer. The bar has been raised for managers to justify their costs, which have to be carefully considered as part of any due diligence process.
The trend we have observed for a while is that disillusioned investors, disappointed with performance, no longer trust that their active managers can generate sufficient excess returns to justify their fees. As a result, they are increasingly moving towards cheaper passive vehicles or they are going down the middle path of alternatively weighted indices which harvest well-documented risk premia in a systematic way.
But how should you actually assess these fees? Is picking them up from the factsheet sufficient or should you consider a different approach?
Fees Three Ways
Today we would like to serve you your fees three ways to provide you with a different perspective.
A. First, fees as a percentage of your initial investment
This is the most common way to consider fees. We looked at all the funds in the IA 40-85% sector, calculated the average TER and arrived at the figure of just below 2% (1.6% in fact). This does not come as a big surprise.
However, cost-effectiveness is not just about offering fees that are five or ten basis points less than your competitors. It is about offering a well-diversified portfolio that is expected to deliver attractive net-of-fees returns within its risk parameters and withstand changes in market conditions. Hence, it is important always to consider charges in the context of fund performance.
This is when things start to look more interesting. When one evaluates fees as a portion of realised historical fund returns (since summer 2013), the picture is quite different.
B. Fees as a portion of realised historical fund returns
On average, for the analysed sector, almost 20% of annualised fund returns is eaten up by fees. Even though the historical performance is not a reliable indicator of future results, such a simple shift in perspective could potentially have a significant impact on investors’ decision-making process. If anything, if you agree that we are entering an environment of lower returns compared to those seen in the past, the portion consumed by fees is only likely to increase.
Finally, multi-asset funds are designed to provide the 'diversification bonus' and attractive risk-adjusted returns. By combining your equities with a number of uncorrelated asset classes, one hopes to generate performance above and beyond what is implied by the fund’s market exposure (beta) - we call this the (hopefully) positive residual return an ‘allocation alpha’.
C. Fees as a portion of allocation alpha
This is essentially what investors are paying for when they invest in a multi-asset proposition instead of a conventional equity tracker combined with a cash holding, so it would appear to be appropriate to measure costs in the context of the ‘allocation alpha’ a given fund can deliver. So how does it stack up for our sector average?
It seems that on average, almost half of the allocation alpha is consumed by fees!
Our analysis shows that building a well-diversified portfolio more efficiently and focusing on passive building blocks may reduce that portion to less than a quarter. Regardless, conceptually these are still levels that are very different from the few-basis-point differences we first notice when we compare competitive factsheets.
The question ‘How much do I pay?’ needs to be accompanied by ‘What do I actually want to pay for?’. We hope that the ‘fees served three ways’ example we've described here adds to the investors’ toolkit and allows people to make more informed investment decisions.
Maybe, after all, there ‘ain’t no such thing as a free lunch’, so let’s at least get a better grip on the bill that, sooner or later, is likely to land on our table.