Nicola Barber offers some advice on navigating investment management fees.
In a beauty parade of potential investment managers you would think that comparing fee quotes from competing investment houses is straightforward: taking the fee given in a tender document and ranking from least to most expensive, right? Unfortunately, when it comes to investment management, what should be a simple exercise is fraught with potential pitfalls due to the lack of standardisation and clarity across the industry. The good news is that regulatory pressure to increase transparency on fees is increasing; a further review by the Financial Conduct Authority (FCA) is due to be published in 2017. Getting a clear picture of who offers value for money is not impossible, but requires knowing the right questions to ask and, as ever, a little work interpreting the language used.
What is the starting point?
At the outset, an investment manager will provide you with an annual management charge (AMC). This is usually given as a percentage of assets, rather than a fixed cost or time charge and is typically levied against the portfolio quarterly in arrears. Principally, the AMC covers the cost of investment management services and administration such as research analysis, portfolio management, consolidated reporting and investment updates, cash management and a formal investment management agreement. In other words, it encapsulates all elements of the regulatory, financial, operational and compliance functions.
What else might the AMC include?
Investment managers may include a number of other services as part of the AMC. Is the safe custody of assets included? What about ethical screening or a sustainable investment approach – is this service extra? Are there any initial, transition or exit charges? When does the manager begin to charge you the AMC? We exclude all cash balances until the portfolio is fully invested. This may take a number of weeks – or even months – depending on market conditions. Others may begin charging from the initial transfer of assets.
Any one-off charges that apply should also be made clear. For example, some investment managers charge a performance fee to further incentivise delivering the investment objective. If relevant, what performance target would trigger this? Is it equitable and how much would it cost?
How much will third-party or pooled funds cost?
It is common for investment managers to include pooled funds as part of their investment strategy. This is to achieve greater diversification across sectors or to gain access to specific markets or themes; such as specialist healthcare, technology, commodities, commercial property. Doing so may offer better risk-adjusted returns than investing directly.
Some managers will have the resources to use their company’s internal funds. The obvious benefit is lower costs – a charity is rarely double-charged so it is usual for the internal funds to be excluded from the fee calculation. Some investors are wary of investment houses that populate portfolios with in-house products rather than using best of breed, externally managed funds with, often, different styles and/or research capabilities. Are the internal funds used, therefore, because they are cheap or because they are the best?
While external, or third-party funds, may have higher costs associated with them (though different share classes mean that investment firms may get better pricing due to economies of scale) these costs may be justified by higher and more consistent performance returns.
Managers may also quote a total expense ratio (TER) which estimates the overall total cost including the costs of investing in these third party funds. Cost estimates should be quoted to you, based on each fund’s ongoing charges figure (OCF), to help you to compare the total cost of portfolios. The OCF is a European standard for charges disclosure that includes all management and portfolio administration costs. Third-party fund charges will not appear as a separate bill to you on an ongoing basis, however, as they are taken out of the fund’s returns.
Is the TER the whole story?
The TER should include all charges made by both the manager and any third parties, however it is worthwhile ensuring you receive a breakdown of what is included in the figure. A line item you should see relates to transaction or dealing costs. These are the costs of buying and selling assets in the portfolio, such as broker commissions. The more transactions, or higher turnover in a portfolio or fund, the higher these are likely to be. The type of assets invested in will also impact this cost, thus it is sensible to discuss the approach with the manager upfront.
Am I liable for tax? The tax implications of an investment portfolio should not be overlooked. VAT is charged on the AMC of charity portfolios and within funds, including common investment funds (CIFs), though recent court decisions suggest some charities may be able to reclaim some VAT on investment fees. Helpfully, the new charity authorised investment funds (CAIFs) are subject to an automatic VAT exemption. It is also worth keeping in mind too that stamp duty land tax (SDLT) is ordinarily charged on purchases of stocks or property. Charities receive an exemption but this is only viable if investing in a charity-only investment vehicle or bespoke portfolio. Minimising the tax bill is sensible to maximise the investment returns to the charity.
Are the performance figures shown after fees?
All too often, the conversation regarding fees remains in isolation from the performance achieved. No charity simply wants to appoint the cheapest manager, if they are also the worst performer after fees are taken out of the equation. This is why net-of-(or after) fees performance figures are important to decision-making. You may have to specifically ask for these to be provided to you. Be aware that at present for example, some CIFs quote performance gross (before) fees on marketing literature. They also publish the AMC in most literature and not an OCF, although the new CAIFs will be obliged to publish this. Finally, make sure you know which fees have been deducted from the figures – preferably all fees – so that you can compare like with like.
Does the approach deliver my objectives?
Fees and performance are of course only part of the decision-making process. A key factor should be the risk taken to achieve those net-of-fees returns. Is your board comfortable with the potential capital loss (known as drawdown) and variability of returns historically associated with such an approach? The figures may look outstanding, but are you comfortable with how they got there? Do you think their methodology is sustainable or based on luck? Ultimately, the board should look for the best risk-adjusted, net returns that fit with your charity’s investment objectives.
Service is incredibly important too. Investing in a pooled fund alone comes with many benefits, and for some very small charities may be the only option. Typically, however, you get what you pay for; an arms-length relationship and standardised reporting. If your charity has specific requirements – an ethical approach, income target or financial objective that requires discussion and timing, or meeting with the investment decision-maker periodically – a unitised fund is unlikely to be appropriate.
Getting value for money for your charity requires both knowing what you are really spending and what exactly you get for the cost. Broadly speaking, charges applied to a charity investment portfolio fall into two categories; those from the manager, and those made by third parties that are passed on to the charity. Both are relevant to the returns generated and should be made clear at the outset. Performance should be considered after fees are taken into account. The lack of transparency in reporting fees can make it difficult to compare apples with apples. However, armed with the right questions, the task is not insurmountable.
Key questions for an investment management tender
- What is your annual management charge, what does it cover and when do you start charging it? Are custody and nominee services included?
- Will we be subject to an initial charge to set up, or a redemption charge to close the portfolio?
- Do you charge a performance fee and what is the trigger and benchmark?
- Are there extra charges to meet our ethical/reporting/investment requirements?
- Do you use external funds? How are funds selected and what is the cost to us based on the ongoing charges figure? If you use internal funds, what is the cost to us based on the ongoing charges figure?
- What is your estimated turnover rate and associated transaction/dealing costs?
- Are we subject to VAT?
- What is your total costs estimate?
- What is your performance net of all fees?
- What kind of service will I get for my fees?
Nicola Barber is head of charities at James Hambro & Partners
Civil Society Media wishes to thank James Hambro & Partners for its support with this article