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The opportunity cost of low fee structures

Beware the investor who knows the price of everything but the value of nothing. While fees are important, fund managers should ultimately be evaluated based on their ability to add value to a portfolio.



Beware the investor who knows the price of everything but the value of nothing. Fees are obviously important, but managers should ultimately be evaluated based on their ability to add net and real value to a portfolio.

The fees and costs associated with fund management and superannuation have rightly become an important concern for investors. It is natural that all investors want to acquire the ‘best’ possible investment option at the lowest possible cost. Particularly in today’s world of sustained low cost of capital, maximising net income and returns are hugely important.

Focus on net returns, not only costs

In the ongoing debate surrounding fees, too many investors are putting the cart before the horse. Common sense dictates that when comparing fund manager performance, the logical metric on which to focus is net return after fees and taxes. But by approaching investment strategy with a ‘fee budget’, investors are eliminating from consideration the very investments that might help them achieve higher net returns.

By way of disclosure, I joined an industry super fund close to its launch, and continue to have all of my super managed by the same fund. So I am raising this issue as a member of the industry fund structure. To paraphrase Peter Drucker, that which gets measured gets managed. Wearing my other hat as a principal of a major fund manager, my bias is towards metrics directed at diversifiable, sustainable and net returns, after fees and taxes.

There are of course other costs associated with superannuation, such as custody and administration, to name but two, and we should not confuse these separate issues. To be clear, my comments here are squarely focused on management fees charged by product providers.

The broad conversation on the fees and costs associated with our industry is healthy and welcome. It is particularly positive given the likelihood that future costs of capital, and ultimately asset class gross returns, will likely be noticeably lower than yesteryear’s ‘CPI++’ asset class medium-term returns. Today, even the most optimistic forecaster is struggling to suggest any normalised gross returns above CPI. And if we add health care as yet another future expense needed to be immunised, a likely benign real cost of capital environment proves even more problematic for investors.

My concern, nonetheless, is that as the long term cost of capital and asset class returns remain benign, almost by definition the need to break away from benchmark returns will increase. By committing to a more rigid fee budget, perhaps a consequence is the inability to access a more diverse and less benchmark-aware product pool.

To make matters worse, it appears as though within this low return world comes increased market volatility and uncertainty. In my view, we have migrated from a world of market ‘volatility’ to one of ‘uncertainty’. Whereas volatility can be quantified, market risk and expected returns are becoming all too difficult to quantify. Looking at historical data from similar periods of prolonged market instability – the US in the 1970s and Japan in the 1990s – may give a sense of what this may mean to investors. During these periods, these market indices were ranked fourth quartile within market league tables, even on a net of fee basis.

Closer to home, if one looks at benchmark-agnostic Australian equity funds with truly long term track records, they surely wouldn’t exist were they unable to deliver net returns above benchmark. In the Mercer Universe of long-only Australian equity managers over a ten-year period, the median manager has outperformed the index on a net of fees basis. This should appeal to the average fund member. There is also a common misconception that active funds are more volatile than the broad benchmark. It’s the benchmark which has shown larger increases in volatility, at least more so than the active manager’s net returns.

SMSF asset allocation

Ironically, while fees impact all members and superannuants, the focus of the debate has been more pronounced and visible within institutional and industry super funds. We have seen a growing army of individuals opting-out of well-diversified industry and retail funds in favour of their own SMSF. The size and depth behind this growth continues to astound me.

According to recent ATO statistics, the SMSF asset pool is heavily skewed towards cash and term deposits. Even under normal circumstances, let alone within this low return environment, this asset class is least able to fund retirees. When one considers that administration and charges associated with running an SMSF often exceed their gross nominal cash or term yield, how ‘safe’ is cash when immunising future pension income?

Any share allocation which may exist is often directed to a mere handful of blue chip Australian names, and almost zero allocation to offshore investments. In the cases where SMSFs do access actively managed Australian equity funds, it’s often through Listed Investment Companies (LICs) where, ironically, management fees and entry charges (the cost of an IPO, for example) can be prohibitive.

Many SMSF holders do not appear to appreciate the extent of the choice and level of control that industry or retail fund members already have in selecting investments. It is individuals’ desire for control, combined with a blind spot to the actual costs of establishing and running their SMSF, which has helped fuel the SMSF behemoth.

So we now have a situation where some institutions appear overzealous within their fee budgeting, while at the same time, many individuals almost disregard fees and charges within the continually growing SMSF sector.

Preoccupation with lowest fee options

This focus on fees needs moderation and greater debate. Moving towards the lowest fee option may only lock in broad market volatility. Equally, seeking one’s independence can often be the highest fee option. Either way, my fear is that some will confuse price with value, or more specifically, with value-add.

Fees do matter, but they don’t matter more than sustainable net total returns (net of fees, taxes, and of course, inflation). It is important to remember that in the long run, the lowest fee option can have the highest opportunity cost.

Rob Prugue is Senior Managing Director and Chief Executive Officer at Lazard Asset Management (Asia Pacific). His views are general in nature and readers should seek their own professional advice before making any financial decisions.

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