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Can these multi-billion pound funds justify their expensive fees?

25 February 2015

FE Trustnet’s head of content Joshua Ausden has no issue with funds that are able to justify above average fees, but asks whether those that attract vast assets should be making more of an effort to bring down their costs.

By Joshua Ausden,

Head of FE Trustnet Content

Blanket criticisms of expensive funds are flawed in my opinion. Yes, higher ongoing charges mean fund managers have to work harder to generate returns for investors, but performance data is inclusive of fees. It costs money to run a successful fund, and if managers are able to justify their expenses with outperformance, fair enough.

The argument doesn’t end there though. While there is a case for expensive funds, that doesn’t mean their cost base should be static. Funds that are able to grow their assets organically and through inflows benefit from economies of scale, but FE Trustnet research suggests that such benefits are often not enjoyed by underlying investors.

US economist Burton G. Malkiel sums up the cost advantages of larger funds in his book Asset Management Fees and The Growth of Finance: “There should be substantial economies of scale in asset management.”

“Brokerage commissions are likely to be similar for each purchase ticket, as are the custodial fees paid to the bank that holds the securities that are owned. The due diligence required for the investment manager is no different for a large mutual fund than it is for a small one.”

Malkiel found that the average cost of mutual funds in the US has barely changed over the past 35 years, even though assets have increased more than 100 fold. Looking at the charges levied by some of the largest funds in the IA universe, it seems there is a similar trend on this side of the pond.

All of the ongoing charges figures (OCFs) that follow refer to the default retail accumulation share class available on the Trustnet Direct platform. Any negotiated fees with fund groups have not been included.  

In the new world of clean ongoing charges, it’s very common for sub-£50m funds to charge well in excess of 1 and even 1.5 per cent. Given the margins up for grabs at this level, this is totally understandable – particularly for those run by boutiques. Groups prioritise bringing down costs as soon as they are able, to ensure they are more competitive.

At the higher end of the scale, there is less of a need to bring down fees – particularly if the fund has a stellar track record and is run by a highly respected manager.

Take the £4.5bn Jupiter Merlin Income Portfolio, for example, run by the FE Alpha Manager duo of John Chatfeild-Roberts (pictured) and Algy Smith-Maxwell, which has an OCF of 1.6 per cent. As well as being the largest in the IA Mixed Investment 20-60% sector, it is also one of the most expensive.

The fund of funds structure tends to result in above average fees, as there is essentially a double layer of charges. However, with an annual management charge (AMC) of 0.75 per cent, the 0.85 per cent in extra expenses is very high. Other large fund of funds vehicles such as the £1.5bn Schroder MM Diversity and £933m Old Mutual Voyager Diversified portfolios charge 1.22 and 1.23 per cent respectively.

When contacted, Jupiter made no reference to the issue of economies of scale or the significant difference between AMC and OCF, instead highlighting the importance of putting costs in the context of performance.

Size and cost of funds

     

Source: FE AnalyticsTrustnet Direct

“As a truly active management house, we aim to deliver outperformance over the long term after fees, without exposing our clients to undue risk.”

“We believe if a fund manager is likely to produce outperformance over the long term after charges it is worth paying more for him or her. The evidence is that fund buyers continue to select funds on the basis of performance and cost rather than cost alone.”

It’s a similar story for the popular Aberdeen Asia Pacific Equity fund, run by Hugh Young and his team, which has an AMC of 1 per cent and an OCF of 1.22 per cent. The fund is £2.1bn in size, but if the Luxembourg-domiciled version is included this figure rises to over £7bn.


Like all of the funds mentioned here, the fund is a very strong long-term performer, but rivals such as First State Asia Pacific Leaders and Schroder Asian Alpha Plus are much cheaper, charging 0.9 and 0.94 per cent respectively.

Again, Aberdeen decided to focus on the sizeable costs associated with running a successful emerging market fund.

“Our whole investment approach is about being good stewards of investors’ money. This involves undertaking a huge amount of work ourselves before investing: meeting with company management, possible site visits and detailed analysis of the balance sheet and business model.”

“This focus on stewardship requires significant on-the-ground resource located in the regions in which we invest, for example we have around 40 investment managers based in Asia.”

Standard Life GARS, one of the largest funds in the IA universe at over £23bn, has recently been criticised by ratings agency Fund House for having“disproportionately high” costs.

Some of the group’s larger funds are also well above average in terms of size, including the £815m UK Equity Income Unconstrained and £1.3bn UK Equity Unconstrained funds, which both charge 1.15 per cent. Many funds across the IA UK Equity Income and UK All Companies sectors charge less than 0.8 per cent.

Performance of funds and sectors over 8yrs

 

Source: FE Analytics

Jacqueline Lowe, head of UK wholesale at Standard Life, said: “We conduct regular reviews across our whole fund suite to ensure that our charging structure remains consistent, competitive within the market and also offers value for money to our investors.”

“Over the longer term, both of the Unconstrained funds have generated industry leading returns on both an absolute and a risk-adjusted basis. This long-term performance has been driven by the strength of insights we are able to generate through our ‘Focus on Change’ investment philosophy – incorporating advanced risk management techniques and portfolio construction.”

“Having a specific Unconstrained mandate means having a concentrated portfolio and while some fund managers may choose to dilute a strategy to accommodate fund flows – we will not.”

It’s not just equity funds. The best-selling fund in the entire IA universe of recent years is the £24.6bn M&G Optimal Income portfolio, which has attracted almost £4bn in the last 12 months alone. It has an OCF of 0.91 per cent, making it more expensive than many equity funds. There are a handful of much smaller options in IA Sterling Strategic Bond that charge less than 0.7 per cent, such as Fidelity Strategic Bond.

Somewhat strangely, M&G Optimal Income is significantly more expensive than other funds run by star manager Richard Woolnough (pictured). His £5bn Strategic Corporate Bond and £5.3bn Corporate Bond funds charge 0.66 per cent, for example. These two have AMCs of 0.5 per cent, whereas Optimal Income charges 0.75 per cent.

M&G were unavailable for comment.

As already highlighted, these funds are amongst the best performers in their respective asset classes, growing many investors’ wealth in recent years. However Mark Dampier, head of research at Hargreaves Lansdown, says multi-billion pound funds should pass on the benefits of economies of scale to their clients.

“Most of these groups aren’t taking on more and more analysts as assets go up. The cost of running the fund doesn’t really increase, and I think groups are getting away with it,” he said.

“There are some funds out there that are charging 30 basis points or more above AMC. That’s outrageous in my view. In some cases you’re seeing fund groups actually up their prices by 15 basis points as they get bigger. Imagine if platforms like Hargreaves or Fidelity did that?”


John Blowers, head of Trustnet Direct, agrees. He says platforms have made an active effort to bring down costs post-RDR, but many fund management firms have not.

He commented: “In the past funds were charging 0.75 per cent and platforms were charging 0.75 per cent. Post RDR platforms have made a real effort to cut their prices, in our case to 0.25 per cent. The fund groups themselves have done very little.”

“Fund managers often talk about wanting to invest in companies that have the best interests of the shareholder in mind. I don’t see why this should be any different for unit holders in funds.”

Dampier and his colleagues highlight Terry Smith’s £3.3bn Fundsmith Equity fund as one that has disappointed him with regards to cutting fees.

When Smith launched the fund back in 2010, he said he wanted to expose the “broken” fund management industry by launching a low-cost product.  Initially an AMC of 1 per cent was significantly cheaper than his rivals, but the rise of unbundled fees means he now has little edge from a charges point of view.

David Smith, an investment manager on Hargreaves Lansdown’s multi-manager team, says he was under the impression that Smith would cut his AMC as assets increased. This hasn’t been the case, however.

Fundsmith says that OCFs are misleading, as they don’t include additional costs such as trading fees and taxes. The firm has worked out that the total cost of owning the fund has fallen from 1.24 per cent in 2012 to 1.13 per cent in 2014, and argues that this makes it significantly cheaper than the majority of its rivals.

Hargreaves’ Smith doesn’t dispute this point, and acknowledges that the performance of the fund has been very strong. However, he thinks Fundsmith and other groups running multi-billion pound portfolios should be making more an effort to reduce fees. 

“I don’t doubt the fund has lower overall costs than most funds or there has been some benefit from economies of scale. However, there has been no reduction in the AMC as the fund grew, which I understood was the plan,” he said.

“The argument seems to be that since Fundsmith spends less on stockbroking commissions it is OK for it to take out higher AMCs.”

“We don’t dispute the fund’s performance or the benefits of a low turnover strategy. However, we struggle with the non-sequitur that it is therefore OK to charge clients more for trading less, especially on a fund where the manager laid an expectation of reducing fees as the fund grew in size.”

FE data shows that Fundsmith Equity has been the best-performing fund in the IA Global sector since launch, returning in excess of 104 per cent.

Performance of fund, sector and index since launch

 

Source: FE Analytics

All of the groups mentioned were contacted, but none made any reference to economies of scale. But do they need to justify themselves?

Gavin Haynes, managing director of Whitechurch Securities, has some sympathy with fund groups that refuse to bring down their costs.

“There is a justification. As long as a fund group can continue to outperform and charge in line with its peer group, from a commercial point of view they are entitled to maintain fees irrespective of how successful they’ve been,” he said. “It comes down to supply and demand.”

David Jane, manager of the £421m CF Miton Special Situations fund, goes a step further, arguing that heavily discounted fund fees could do more harm than good.

“It would be a tragedy if all the biggest fund houses that tend to attract the most money cut their costs. It could get to the stage that they have a disturbing competitive advantage. All that’s going to do is encourage a race to mediocrity,” he said.


While Haynes does have sympathy, he says top-performing funds with above average fees are treading a fine line. He believes the 0.91 per cent charged by M&G Optimal Income is expensive, for example, especially given how low yields are on bonds at the moment.

“If the fund can continue to outperform then fine, but if there is a period of underperformance you could see some pressure there,” he said.

“The groups [that are bringing down fees] have a competitive advantage. We are now looking at fees more than ever before.”

There’s no shortage of funds that have significantly brought down costs as assets have risen. The £1.7bn Royal London UK Equity Income fund – by far the most consistent in the IA UK Equity Income sector – charges just 0.67 per cent, for example. In the closed-ended world, multi-billion portfolios such as City of London, Scottish Mortgage and Temple Bar all have ongoing charges of 0.5 per cent or less, and don’t charge a performance fee.

Haynes adds that the fixed 0.75 per cent OCF offered by Neil Woodford’s CF Woodford Equity Income fund is “a potential game changer”, and envisages that other groups may be forced to review their cost structure in the future.  

FE Trustnet will compile a number of articles in the coming weeks highlighting highly-regarded cheap funds, as well as “expensive” funds that are worth paying up for.

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