Too Much Navel-Gazing?

For those who have missed it, there’s been an entertaining debate this week on the subject of costs in the fund management industry.

It started with an intervention from Alan Miller, reported in Monday’s Guardian, in which Miller argued that the £4.3 billion in annual management charges levied by London fund managers are dwarfed by an additional £5.8 billion in additional costs, primarily dealing commissions, taxes and market-making spreads (according to a subsequent news story in the Times).

(Coincidentally, I wrote a feature on the very same subject earlier this week, the second part of which will be published on Monday).

In Citywire, Lee Robertson, CEO of Investment Quorum, responded to Miller by pointing out that he (Miller) was hardly best-placed to criticise fee levels, given that he had earned a multi-million fortune at active manager New Star running actively managed portfolios, including high-fee hedge funds.

Miller’s central argument, according to the Times, is that “fund managers’ fee scales, whether in the retail or the private client sector, tend to be highly complex, shielding the true cost of their services from investors and leaving many clients with a raw deal.”

Having spent some time over the last few weeks trying to understand how fees are levied, I fully agree with Miller about the complexity of charging structures, though I suppose that the funds industry is no different from many other sectors of the economy. Does anyone understand mobile phone contracts?

Ed Moisson, funds expert at Lipper FMI, added a level-headed voice to the debate yesterday, arguing that trading-related costs must be applied on a consistent basis across Europe and also across asset classes. No methodology to do this has yet been developed, he points out. Moisson also queries whether the “extra” £5.8 billion in charges reflects some allocation of initial charges (entry fees) to overall costs. The impact of entry or exit fees terms obviously depends on your holding period.

Why there might be difficulties in developing a consistent measure of trading costs can be seen just from a small subsector of the funds market. ETFs can have wildly differing levels of internal trading activity, it turns out. Just a cursory look at the October issue of Morningstar’s ETF Investor magazine shows that turnover levels range from truly “passive” funds, with annual turnover rates of a few percent (the lowest I spotted was 2% per annum for the iShares FTSE EPRA/NAREIT Developed Real Estate ETF), to those with turnover rates of several hundred percent (519% for the iShares Barclays Aggregate Bond ETF, for example). To understand why these turnover levels occur you need to dig deeper into the way the ETF’s underlying index is constructed and what tracking methodology the manager uses.

Of course, high turnover in markets with wafer-thin dealing spreads, such as in government bonds, may be perfectly acceptable, while even a few extra percentage points of buying and selling in less liquid areas of the equity markets can create a significant performance drag.

But beyond these technical difficulties of arriving at a “fair” cost measure, is there a danger of navel-gazing in this whole debate? Are we now focussing too much on cost and too little on quality of service and performance? Apart from that, it’s worth remembering that some participants in the discussion may have products of their own to sell which, while transparent in their charging structure, may not be cheap (Miller’s firm, SCM Private, offers funds of ETFs with a 0.75% annual levy on top of the underlying ETFs’ charges, plus a 5% performance fee).

In my opinion the fee debate is only really starting. Why? Moisson’s analysis from earlier this year, showing ten years of rising charges for UK fund investors, suggests that the investment industry grew bloated during the last stages of the bull market. The cost divergence between index funds/ETFs and actively managed funds in Europe is also increasingly stark. So while Alan Miller may not be a disinterested observer, good to him for bringing the discussion into the mainstream press.

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