FeesMay 2 2017

Investors should not tolerate external research charges

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Chris Traulsen
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Henderson chief executive Andrew Formica indicated on an earnings call earlier this month that the firm would in future be charging investors for external research used to support their investment decision-making processes.

The principal cause of Henderson’s decision is the effective ban on soft commissions wrought by Mifid II. 

By way of context, Henderson – like most fund managers – has long paid dealing commissions (soft commissions) when trading on behalf of their funds in return for third-party research. In this perfectly legal arrangement, the firm and others have used investors’ funds to buy said research without having to disclose the amount spent, and without having to include the cost in the funds’ ongoing charges.

The only reason most people aren’t is that they don’t know they’re being charged extra for the managers to buy in the researchChristopher Traulsen

Historically, and at present, dealing charges and other transaction costs have not been included in the ongoing charge, although we at Morningstar are advocating for this to change.

Mifid II effectively bans this practice. Starting in January 2018, firms will therefore either have to pay for the research out of their own pockets, or add it to the fund’s ongoing charge.

You might pause here and quite rightly question the whole premise of soft commissions. Why on earth would an investor, who is already paying a premium price for active management – the sole point of paying which is to drive outperformance of the market – pay anything else at all for research?

Indeed, it appears that is why actively managed offerings charge so much money in the first place, because they undertake research that will allow them to get an edge on the market.

If you hire a dentist, agree the rate to have your teeth cleaned and then get charged add-on fees for waiting room magazines, cleaning paste, washing of the various items used, the paper gown you wore, and so on, you’d quite rightly be angry. 

The only reason most people aren’t is that they don’t know they’re being charged extra for the managers to buy in the research – research that they are ostensibly being paid to perform themselves.

Other than the obvious implications of being charged extra for a service assumed to be included with the management fee, there are a couple of dangers lurking here. First, if a firm relies on widely sold third-party research too heavily, it won’t be able to differentiate itself enough to outperform.

Second is that investors’ funds will not be spent wisely: if you use your own money to buy something, you are likely to work hard to obtain value for money. If you use others’ money – and if they don’t know that you’re using it – there’s less reason to be so particular.

Some firms have worked out that the jig is up. The FCA is quite rightly breathing down the industry’s neck over a perceived lack of pricing competition in the UK market, passive investments are growing strongly and the days of outsized 35 per cent margins (Henderson achieved a 35.1 per cent operating profit margin in 2016) are looking like they may well be a thing of the past.

In such an environment, the Jupiters, M&Gs, Baillie Giffords and Woodfords of the world have seen discretion as the better part of valour and announced they will simply pay for the cost of research themselves. Henderson, however, is among those who appear determined to charge fund investors. 

Investors shouldn’t stand for it.

Christopher Traulsen is director of ratings at Morningstar