More Price Competition Needed in UK Fund Industry

Expenses are one of the more important determinants of any fund’s future performance. Fees are deducted directly from whatever returns your manager has generated, and their effects compound over time. Yet, in the UK, there seems to be astoundingly little price competition among fund providers, and management charges remain stubbornly high. Given the reliance of individual investors on OEICs and Unit Trusts to save for retirement, the issue must not be taken lightly.

Why Costs Matter
Everyone would like to be able to predict which funds will outperform in the future. Often, investors look to past performance as a way to gauge this probability. The method is somewhat useful if done properly, but it’s abundantly clear that simply buying the funds with the strongest past performance is not a recipe for success. This would have led you to buy a stack of technology heavy offerings in early 2000, for example, setting you up for a nasty fall. Similarly, investors piling into mid-cap and property funds today may well be in for some pain down the road.

To really gauge a fund's prospects, you need to assess many factors, including its management, its strategy and the fundamental risks in its portfolio and operations. But even then, when and how these factors will impact a given fund are difficult to predict with certainty. In that light, one of the most effective ways investors can ensure they have a good shot at strong performance in the long run is to eliminate predictable, persistent drags on returns. The best way to accomplish this is by cutting costs. A fund’s style may drift in and out of favour, managers can come and go, but a fund’s costs eat away at your returns year after year.

The 1.5% Problem
Fine, you might say, investors can simply select cheaper funds. Would that it were that simple. First there are often significant costs imposed on investors who wish to switch from one fund to another. More significantly, there just isn’t much choice in the UK funds market when it comes to annual management fees, easily the largest component of a fund’s ongoing costs. The market offers a robust selection of funds, from a wide array of providers, and yet the majority of them have hit on the exact same fee for their services: 1.5% per year.

The fact is surprising. In a well functioning marketplace, one would expect management fees to be distributed across a reasonably broad range. This is in part a function of the economics of the asset management business: As funds grow in size, providers can charge less for their services on a percentage basis, and still earn enormous profits. Assume a fund has £50 million in assets. A 1.5% management fee amounts to £750,000 per year in revenue for the fund company. Now, if the fund has £1 billion in assets, and the manager continues to charge 1.5%, the fund company will take in £15,000,000 per year in revenue from this one fund. Even if the firm were to cut its fee in half, it would still make 10 times the amount it did when the fund was smaller, for doing essentially the same work. Thus, if funds faced competitive pressures, one would expect to see their management fees vary with the size of the fund.

Instead, the opposite is true: annual management charges are not well distributed at all. In fact, 62% of all retail fund classes in the UK levy a management charge of 1.50% per year (see Figure 1, below).


A (More) Competitive Market
Lest you think this situation is the norm, the U.S fund market offers a useful point of comparison. A quick look at U.S. domiciled retail domestic-equity funds shows a median annual management fee of 0.75% per year (one half the UK median), with a wide, even distribution across the fee level spectrum, as depicted in Figure 2, below. The bars in the chart correspond to 10 basis point increments in annual management charges, and no increment accounts for more than 27% of all fund classes included in the sample.


The logical conclusion is that UK fund managers are not operating in a fully competitive market. Further evidence of this has come over the past two years as large groups such as Henderson, M&G, Threadneedle, and Credit Suisse have raised their annual management charges. In some cases, the fee raises came in spite of poor performance at the firm’s funds. When a company can raise the price of a clearly inferior offering, the system is broken.


Better Disclosure Needed
Part of the problem amounts to disclosure. Sunshine is the best disinfectant, but it’s more difficult than it needs to be for investors in the UK to shed light on how much they’re paying for various services related to their fund investments.

This is an area where the FSA needs to step up to the plate. To operate efficiently and effectively, the participants in any given market need to be operating with complete information. In the UK fund market, management fees are disclosed, but the total ongoing cost of funds, as encompassed in the total expense ratio (TER), was not commonly disclosed by UK-domiciled funds until the European Union’s UCITs regulation started requiring UCITS funds to do so. Even now, UK funds that are non-UCITS retail schemes (so-called NURS funds) do not have to disclose their TERs. The result is that many investors may have the false impression that annual management charges are the sum total of their ongoing costs—and thus may be willing to pay higher AMCs than they otherwise would.

The FSA could go a step further and force funds to disclose the portion of the TER that was spent on (1) portfolio management, (2) marketing, (3) commissions actually paid out to advisers and platforms, (4) custodial services, and (5) shareholder services. If the FSA were to require disclosure of these items for all funds, based on uniform definitions, fund shareholders would be in a much better position to assess whether they are getting value for money for the array of services that are bundled into a typical TER.

Investor Education
Another obstacle is investor education. It is true that fees have a relatively small effect in any given year, but their impact compounds over time, costing investors tens of thousands of pounds or more, by the time they retire. Getting investors to focus on this mundane fact rather than short-term performance is a tough exercise.

The FSA, to its credit, has tried to get at this by requiring all funds to disclose reduction-in-yield figures. The problem with these numbers, however, is that they use assumed rates of return that investors may well dismiss as unrealistic or irrelevant, and they conflate sales charges with ongoing fees. Further, they use the fund’s maximum stated sales charge, which most investors know they will not have pay. The net effect is a figure that is of questionable relevance for many. Ensuring that all funds disclose a TER in addition to the reduction-in-yield figures would be a step forward in this regard.

The Life & Pension Problem
A problem that cannot be ignored is the opacity of fees associated with many life and pension funds. Once a fund is offered through an insurance wrapper, all the disclosure requirements that apply to OEICs and Unit Trusts no longer apply to the "wrapped" version—a loophole big enough to drive a good sized lorry through. The FSA needs to require full, consistent cost disclosure across these offerings, with the cornerstone being the TER of each offering, including any ongoing charges applied by the insurance company and by the fund itself. Providers should also be required to disclose clearly any sales charges or other fees as a percentage of assets.

Shareholder Representation on Fund Boards
Finally, it’s worth noting the lack of shareholder representation on fund boards. OEICs in the UK can operate with only one director - the management company - if they choose. Most, of course, choose this structure. Thus, when a fund company wishes to raise its charges or tries to do something else that could well damage the interests of current shareholders, there is quite literally no one to step in and question the activity other than the fund company itself. The structure is particularly problematic in the funds industry: Fund investors are a broad, fragmented group who have little power as individuals to effect change at a given fund. The management company, on the other hand, acts with complete information and its interests may often be in direct conflict with those of fund shareholders. Having a shareholder / investor representative on the board would help ensure their interests are protected.