Aug 19 2016

Because they’re worth it

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Because they’re worth it

Cost dominates a great deal of the decisions we make. Frugality is a trait well served in a world that has become absorbed with the importance of money. The amount we earn and spend can play a key role in affecting our comfort and happiness.

In the personal finance industry, costs and charges are of constant focus from companies and the regulator. The RDR aimed to deliver more transparency for investors when calculating and comparing the costs of obtaining advice to achieve their financial goals.

Before the RDR was introduced, investors would generally be charged an initial fee for new transactions. This was in the region of 2 per cent to 5 per cent and levied regardless of whether advice was taken or not because the equivalent sum was then used to fund adviser commissions.

But this does not represent the only cost, as the firm and individuals managing the underlying investment assets still need to be remunerated.

The reason why investors pay these charges is to access the knowledge and expertise of a specialist manager who aims to achieve higher returns than a fund would tracking either a benchmark or index. However, some are sceptical that these managers are actually justifying the fees.

“The industry wants investors to believe that performance is the key factor, but it’s all about cost,” says Nic Round, managing director at Shrewsbury-based Treowe Wealth Advisers.

Mr Round explains that, given the unpredictability of investment performance, it is difficult to choose funds that present the best value, and says it may be better if managers adopted a bonus on-growth arrangement with the clients’ agreement. The industry “wants its cake and to eat it”, he adds.

But not all advisers share this view. Dean Mullaly, managing director at Mark Dean Wealth Management in London, says, “Whether the fund charge is high or low doesn’t really matter. But it matters what the manager is doing for that. If there’s a fund charging 1 per cent [pa], but growing 15 per cent a year, is top quartile and five ‘crown’ rated, that’s worth paying for.”

Paul Gibson, chartered financial planner and managing director at Aberdeenshire-based Granite Financial Planning, does share that view. He says, “Fund charges are hugely important as controlling these is probably the most significant factor in producing a good investment outcome for clients.”

Cleaning up the classes

Purely just selecting the correct share class for an investment has become more complicated in recent years. Previously, commission was built into the fund charges, but the RDR stipulated that this had to be removed, as adviser and manager fees must be separated. As existing share classes could not be adapted to cater for this, new clean shares needed to be issued, with significantly lower management charges, as any commission has not been added.

Generally, share classes are split into institutional and retail categories and funds are separated, aiming to accumulate or generate income.

The new clean share classes are of greatest benefit for investors who have not taken advice, as the reduced cost results in less capital erosion. Many firms have taken this further by offering super-clean shares, which reduce the annual charge to attract substantial investment. However, because of the number of share classes now available, selecting the correct one has not only become confusing for investors, but also advisers.

“It has gone a bit crazy,” says Mr Mullaly. “There was a big mistake made at the beginning – the FCA should have come down fairly strongly on this. Some groups have got 30 share classes on a particular fund, and I cannot see which is the clean one.”

Regular churning of stocks and accessing specialist markets can drive up fees in the hands of the investor. This is an issue that some advisers feel should be less ambiguous and emulate the transparency driven by the RDR.

“If I had one wish, I would request that fund transaction costs were fully disclosed as these represent a significant cost leakage from funds, which largely goes unreported,” says Mr Gibson.

Beating the market

A direct correlation applies to the amount charged within a fund and its performance. Simply, if a specific fund has a total annual charge of 2 per cent, growth will need to surpass this every year just to show a positive return. Notwithstanding, potential income and/or capital gains tax, plus the impact of inflation, provide hurdles for the manager to validate the fee.

But this is the arena for good managers to earn their stripes by conducting thorough research and using specialist knowledge, to reach the ultimate objective of consistently ‘beating the market’.

“Behind the science of investing lies a fundamental truth – fees reduce the efficiency of a fund or portfolio,” says Kusal Ariyawansa, chartered and certified financial planner at Appleton Gerrard in Manchester.

He adds that managers can add value by making “insightful calls”, which should be evident in their track record. But he explains that not all investors are experiencing this. “What [investors] do not expect is novice, career-evolving guesses that result in sudden double- digit losses which then take years to recover.”

A venture too far?

Venture Capital Trusts (VCTs) come under scrutiny for charges, as they are often viewed as expensive regardless of attractive tax benefits. The data in Tables 1 and 2 adds weight to this, as the VCT charge plus performance fees in the Generalist sector is 3.31 per cent pa, including potential performance fees deducted from growth.

Investment trusts – another vehicle often seen at the upper end of the cost spectrum – have substantially lower fees at 2.28 per cent, including any performance bonus when analysing the average for the UK Smaller Companies sector.

There appears to be some correlation with the performance, as the average investment trust has outperformed the average VCT on a five- and 10-year basis.

However, it is important to bear in mind that these sectors are not necessarily comparable with each other.

Open-ended managers are able to drive these ongoing costs down even further, with the average fund charging 1.56 per cent, which is less than half of the average VCT. Advisers are beginning to sense that costs attached to VCTs are something that should be addressed.

“[VCTs] still seem to be in the old world of 2.5 per cent initial charges and performance fees of 20 per cent. That’s not value, that is cost, as I don’t see any value that they’re adding for that,” Mr Mullaly says.

He explains that VCT providers attempt to justify the initial charge due to the 30 per cent income tax benefit for investments up to £200,000 pa, but adds that this charge does not provide a barrier to recommending VCTs to clients albeit with a sense that the cost is unfair.

“It’s difficult – I have to use them because it’s the right advice, but it feels like they’ve got their hand in your pocket at the same time.”

Mr Ariyawansa agrees there are exorbitant costs within VCTs, especially when being considered by ordinary investors. He says, “Tax relief should be seen as a bonus and not form part of the final projections or act as an incentive.”

Digital threat

Digital advice solutions should ensure this debate continues, as concerns grow about online advice platforms, and their ability to drive down costs to the extent where advisers could be cut out altogether.

“Change can – and possibly will – be brutal,” says Mr Round. He suggests that digital platforms will challenge advisers and managers to justify asset management fees.

“An adviser who picks funds might as well go and retire. A client looking at the new way in which money will be managed will be able to drive down costs.

“And if you are a fund manager then you have to be doing something really special to survive in the new world,” he adds.

With many organisations looking to capitalise on cost-effective and easy-to-use advice solutions, charges for managing investment funds are likely to come under further scrutiny and perhaps be subject to even more regulation.

craig.rickman@ft.com