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Time to ask fund managers the difficult questions

Advisers need to be asking far more difficult due diligence questions to get to the truth on fund management charges, says Abraham Okusanya, director of investment analyst firm FinalytiQ

The saying ‘sunlight is the best disinfectant ‘ cannot be truer for any part of retail financial services than in fund management. The FCA’s paper on fund charges shone the spotlight on the dirty laundering of fund management by calling on fund managers to ditch annual management charge (AMC) for ongoing charge figures (OCF). But this is only a tip of the iceberg; the FCA needs to stop dancing round the edges and force disclosure of ALL fund management costs.

According to recent research by Professor David Blake of the Pensions Institute, up to 85% of fund management charges are hidden from investors[1]. In other words, even OCF doesn’t account for the full cost borne by fund investors. Prof Blake’s paper noted that ‘no good reasons have been put forward for why all the costs of investment management, both visible and hidden, should not ultimately be fully disclosed.’

Every time Mrs Smith walks into her adviser’s office to top up her ISA, a whole chain of reaction is set in motion and the number of ‘entities’ getting paid in the process should make your blood boil.

It is estimated that there are, at least, 11 to 14 service points between a retail client and the stock market. No one really knows the full extent of the hidden costs in the fund industry, but if we did, there would be a public outcry.

Let’s have a go at naming these ‘entities’ between the retail client and the market: Adviser, Platform, DFM, Fund Manager, ACD, Depositary, Custodian, Broker (research), Broker (dealer), CREST, FX dealer, HMRC, Securities lending counterparty. Oh and the FCA! The list in just mind-boggling!

Advisers – the most valuable part of the chain

Advisers, arguably, are of the most valuable part of the chain. Their cost is known and in spite of the scaremongering pre RDR, most clients continue to value and pay for advice. And those that choose not to, are able to make (hopefully) an informed decision based on the costs versus the benefits. But while advisers and now platforms are required to be completely transparent about their fees, asset managers continue to enjoy the luxury of accessing clients’ money without full disclosure and transparency.

The best way to think about fund expenses is to imagine an iceberg – the part above water is insignificant in comparison to the part that is hidden. This unseen part of the iceberg consists of transaction/dealing costs, profits from securities lending, FX spreads and interest retained by managers on cash balances. So, exactly how much is the hidden cost? Pluck a number out of thin air and you won’t be off the mark, because frankly, no one really knows.

There are reliable estimates that put the real Total Cost of Ownership (TCO) approaching 3% per annum for pension funds! I’ll imagine that retail funds are probably similar, and they may be even more. So next time you see an OCF of 90 bps on your fund factsheet, rest assured, you are being lied to.

The IMA is dancing around the edges on the matter. Its draft Statement of Recommended Practice (SORP) proposes that fund managers should declare some transaction costs (mainly trading and research commission) but portfolio dealing spread is optional. And it doesn’t suggest publication of profits made from securities lending; interest creamed off cash balances, transaction costs incurred by underlying funds (where held) and portfolio turnover rates.

It’s been suggested that MIFID II will fix the lack of transparency in the fund industry when it becomes law in 2016 but the IMA says that this doesn’t apply to UK funds.

What role for advisers?

Personally, I think this is where the big conversation is right now. Advisers, as agents of the client, need to be more demanding of asset managers.

Fund selection should include due-diligence that asks managers difficult questions about practices around transparency of costs. How much attention do they pay to portfolio turnover rate? What proportion of stock-lending fees is kept back by managers? What’s the cash drag on the fund? If they won’t tell you, they probably have something to hide.

I also believe that advisers who are able to find ways to reduce cost by avoiding some of these hidden charges are adding more value to clients than those who aren’t.

Clearly the FCA is dancing round the edges on this issue. It needs to stand up, be the big, bold regulator that it claims to be and force disclosure of all fund costs! In the meantime, fund managers continue taking us for a mug – you, me, your clients, the Government – everybody!

[1] David Blake (2014) On the Disclosure of the Costs of Investment Management http://www.pensions-institute.org/workingpapers/wp1407.pdf

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