However, what if we consider this issue through a different lens? What if the extras which fall outside the Total Expense Ratio (TER) that managers quote were clearer, or even lower? What if the investor had greater faith, or even oversight, in what they were signing up to for every manager?
It’s not just fees that need an overhaul, the entire institutional investment model has simply become inefficient.
Consider the case of a very typical UK pension fund of £250 million. It runs a diversified investment strategy consisting of 55% bonds, 30% equities and 15% alternatives, with active allocations to five individual asset managers. What is the right level of costs for the fund and what exactly are they paying for
The most obvious cost is the asset portfolio management fee charged by investment firms, which has become the main focus of the FCA’s scrutiny. In general, this is straightforward to understand – usually a percentage of the fund’s total asset value – although some fees might vary. In ballpark terms, using typical active funds these fees might be around 0.55% per annum for the fund as a whole. Of course, if passively invested, this figure can reduce by perhaps 0.50% per annum for the equity and bond holdings.
The FCA still believes there is more movement to be gained here. That may be so, but we believe that the focus on ad valorem fee levels – which have already come under significant pressure – misses a host of wider inefficiencies or duplications that are easier but equally important to correct.
These other costs affect the overall returns that can be achieved, but can be very readily rectified to the benefit of both parties. For example, and in the illustrative scenario of our fund, it might be meeting 0.55% per annum in management fees, but it could typically be losing a further 0.30% per annum in other costs.
First there are costs relating to the administration of running the pension schemes’ assets – such as custody, accounting, legal fees and the cost of hiring directors. These are relatively easy to find out, and might typically be around 0.10% per annum. Due to regulatory changes, a number of asset classes might also experience an increase in such costs in the future, for example, increased operational fees for central clearing.
Then there are the transaction costs. Although time-consuming to arrive at, it is relatively simple to determine retrospectively the level of bid–offer, tax, commissions and similar costs that reduce a fund’s value over a year. This process is helped by European Regulation through the Markets in Financial Instruments Directive (MiFID II), which makes the provision of trading costs a requirement. Trading costs do vary significantly by fund, and for our illustrative fund, we would expect explicit costs such as commissions and taxes to be up to 0.05% per annum, and the impact of market pricing spreads to be perhaps 0.15% per annum.
This is all relatively straightforward to derive for traditional asset classes, especially with more of the trading costs become clearer under MiFID II. However, what about less traditional asset classes such as hedge funds? Costs charged by Prime Brokers, for example, can include differential funding rates for going long or short, or perhaps additional costs hidden in the methodology for rolling or settling FX contracts.
So, let’s do the maths:
- If a typical £250 million UK pension fund is paying 0.55% per annum (or £1.4 million per annum) for investment management across five fund managers,
- It will be incurring circa 0.30% per annum (or £700k per annum) for administration and transaction costs, replicated across five managers.
Of course this is an average illustration and figures will vary, but if the data in a survey undertaken by the Pensions Regulator are correct, which puts assumed total costs at circa £540k per year, this means that a majority of UK schemes are significantly underestimating their outlay by almost four times.
To put this into even sharper context, £2.1 million in total cost is broadly half a typical sponsor’s deficit contribution.
Do you have confidence that your scheme is not haemorrhaging value unnecessarily?
How can this situation be improved?
What if institutional investors could share the same resources for administration and trading, and thereby not duplicate the same costs across their portfolio?
This would reduce the burden on each scheme and create a stronger, more standardised market – a market in which both the investor and the FCA could have greater confidence. As a result, fees would likely come down too.
That is what an exchange solution offers – a central venue where duplication of effort and cost can be reduced and efficiency prevails.
There is a better way, but we must be willing to peel back the layers of the onion rather than letting the whole picture bring us to tears.