Last month the Office of Fair Trading reported that hidden charges made pension funds poor value; this month the government promised action to cap pension fund charges. At much the same time the head of PIMCO, the world’s largest bond fund manager, complained that capitalism could not survive if returns remained negative.
RDR and management costs
So it is appropriate that many of the more enlightened IFAs have been discussing the costs of investment management, and what should and should not be included within them. Two of the key concerns are linked; what gives the best performance to a client – buying index-linked funds at a lower annual management charge, or buying into a manager who attempts to beat that index albeit at a higher management fee and also, probably, higher dealing costs from an active level of portfolio switching?
Today, all costs to do with investing should be ‘unbundled’, the RDR idea is that investors should be able to see the real charges made by managers of investment funds – whether unit trusts, investment trusts, ETFs or whatever – together with the cost of advice [recommendations from an IFA or stockbroker on what and when to buy or sell] and that of administration, or custody of assets and maintaining records of funds bought, their prices, capital gains tax calculations and dividend history.
Opaqueness of pricing has served both bankers and investment managers well, so neither will be too keen on showing where their profits are made, nor how the costs mount up. It has been calculated that a dozen or more intermediaries nibble away at the returns generated by pensions funds and, while the private investor is not quite so beleaguered, they need to keep a sharper control on costs than they have been accustomed to doing.
Costs are real, profits are promises. This is already being demonstrated by the ‘platforms’ – the currently popular name for a variety of administrative systems that range from the fund supermarkets like Cofunds, Skandia and Fidelity FundsNetwork, to stockbroker-type systems such as Alliance Trust & Savings, to specifically designed ‘wrap’ platforms for the independent investor or IFA such as Transact.
Nearly all of these charge a percentage of assets under management (AUM) rather than the flat transaction fee that was typical of stockbroker administration. Platform costs seem to average out at 0.25 per cent while advisory fees from IFAs and stockbrokers can be another 1 per cent of AUM – few IFAs find it possible to take the RDR’s intended route of an hourly fee.
Those costs must be added to the average total expense ratio (TER) of a typical unit trust of about 0.75 to 0.9 per cent for an actively managed fund, or 0.25 to 0.3 per cent for an index tracker. So investors have a minimum hurdle rate of between 1.5 to 2.5 per cent plus inflation to surmount if they are to grow their savings for retirement; this was possible prior to 2000 but is not so easy now.
A changed world
The banking crisis of 2007/8 was so serious that politicians demanded central bankers behaved in a revolutionary way to save the economic system as they know it. They did so by flooding the world with money, printed by governments, and so successful was this liquidity injection that politicians now believe all problems can be solved by monetary policy – or continued quantitative easing (QE).
But monetary policy and central bankers can do only one thing with certainty – and that is hard enough at the best of times: preserve public trust in the value of money to maintain the stability of the financial system. That main task is put at risk if governments balk at the fiscal and other policies that are necessary, and expect central bankers to do their work for them. QE is driving savers and companies away from the banking system, and from money itself.
Izabella Kaminska of the FT Alphaville team recently wrote that Bill Gross (managing director of Pimco) wasn’t wrong to observe that negative carry is bad for capitalism. “A lack of carry – (‘carry’ or a positive result between the cost of money and the return from it that is necessary for capitalism to work) – inverts the forces of capitalism from good to bad, turning sound corporates into socially destructive entities and banks into pariah agents. In fact it’s difficult to imagine how lenders and banks
can survive at all in a long-term negative carry environment. But what Gross seemingly fails to understand is the causation at play. He sees the zero carry world as the product of state repression, when the intervention is arguably only a symptom of a much more structural economic adjustment.”
No blood from a stone
“QE is not so much a repressive force that muddies capitalism as a technical support that stops it from destroying itself. For the truth is, if and when the market has no carry to offer, you can’t extract it out of the system without retarding or regressing civilised progress. Carry, in and of itself, is not a constant. It is not something we are all entitled to. It is instead a product of a social system, which either has demand for financial capital or not. Thus to bleed carry from a system in the form of rents that it cannot productively offer is to choke the system, rather than to help it.”
A recent paper from the World Bank helps explain the current lack of demand that is discouraging businesses both from updating their capital equipment or investing in new business ventures. The author demonstrates the shift of wealth from the poor to the rich, and from the
West to the East over the past 20 or so years, and says “It was probably the profoundest reshuffle of people’s economic positions since the industrial revolution”. This paper also offers a context for stagnant real median incomes in the UK and the US since the 1970s arguing that if current trends continue, “we should not be surprised to find that the median individual in the ‘rich world’ becomes globally somewhat poorer”.
What can the investor do?
These forces are bigger than central banks or governments, and hardly understood at all. Central bankers and governments can do little to change this larger trend described in last month’s column. Consequently investors must determine what they want from their savings, and accept that much of what they think they know, no longer works. Much of the IFA discussion was on the cost of turnover, or buying and selling securities within a portfolio. This can be substantial, with some unit trust portfolios being turned over three or four times a year. Such dealing might have been profitable in bubble markets, but while the evidence says it is expensive and unprofitable, human nature is convinced of the opposite.
And as another post said, passive versus active investing is lazy thinking. Index tracking is an active policy – switching securities to follow the make-up of an index or other selected benchmark – while active investment should be about using the brain to identify long-term value, not the moments’ fashion. And it is certainly germane that those IFAs that do charge an hourly rate are those that identified the ‘investment trust’ value proposition some years ago.
In March 1933, John Maynard Keynes wrote: “We have reached a critical point ... We can ... see clearly the gulf to which our present path is leading. We must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict.” We must all hope that message is not relevant today.
