A Modest Proposal: Improving Fund Cost Disclosure

As our previous articles (you can see them here and here) have suggested, we believe the annual operating costs of funds in the UK are not well disclosed. Investors are thus unable to ascertain the true ongoing cost of fund ownership. Nor can they determine how much they’re paying for various services, which means that fund companies do not have much incentive to compete on price in any one area.

This is fairly evident even from looking at fund’s annual management charges. In a study we undertook earlier in 2007, we found that the management charges of UK domestic equity funds cluster sharply at 1.50% (at the time of the study, an astounding 62% of the funds in the study had AMCs at this level). In a comparison with the US fund market, two facts are worth noting. First is that the 1.50% level is twice as high as the US median management charge of .75%. Second, there is much greater distribution of AMCs within the US market, suggesting greater competition and certainly greater choice.

The lack of competition is further reinforced by the fact that there is zero pressure on fund companies to share economies of scale with fund shareholders. In other markets, as fund assets under management rise, it is common for the management charge expressed as a percent of assets to drop. In the US, the fee scale is even written in fund prospectuses. For example, a fund manager will be paid 1% of assets on assets up to $100 million, .75% of assets on assets between $100 million and $250 million, and .5% of assets on everything beyond $500 million. Such arrangements in the UK appear to be non-existent, and even the largest funds in the market continue to charge full freight.

Why Fund Fee Transparency Matters
The problem of fee transparency is particularly pernicious when it comes to investment funds. With almost any other purchase, consumers directly purchase the item and have ample ability to weigh the cost versus competing items and retail shops. When it comes to investment funds, however--usually a far more important “purchase” than that liter of milk from the supermarket--investors cannot as it stands access complete, easily comparable, cost information.

The issue is complicated by the fact that most investors outsource the investment decision to their financial adviser. That’s absolutely the correct thing to do in many cases—financial advisers provide a valuable and needed service to investors. However, it opens up the possibility that the purchase decision may be influenced by incentives offered to financial advisers rather than based purely on finding a truly cost effective offering.

A Solution?
The first thing to achieve is simplicity. For investors to make meaningful comparison across funds, they need a single “all in” number that includes all known trading, borrowing, and operating costs and all costs of underlying funds. This is rather like the current UCITs TER, but it loops in two additional costs that measure omits. This number could be published in the same easy-to-find location in every simplified prospectus and fund fact sheet so investors won’t have to thumb through pages of documents looking for it.

Beyond that, we believe it would be helpful for investors and their advisers to have access to a breakdown of what they are paying for each service. Only then will there be any pressure on service providers to compete on cost. Such a breakdown might include the following fee categories, all expressed as a percent of assets on an annual basis:

(1) Investment management
(2) Brokerage Commissions
(3) Estimated Other Trading Costs
(4) Borrowing Costs
(5) Commissions paid
(6) Other marketing costs

Last but not least, it must be said that fund governance in the UK is open to serious question. Put simply, there is no meaningful mechanism to protect fund shareholders against overreaching by their asset management company. If a firm wants to raise fees to fund shareholders, it simply does so. There is no other party representing investors it must first negotiate with.

The model appears to assume that investors will shy away from fund firms that raise fees and that the market will therefore enforce good behaviour. It would be wonderful if it worked. However, the assumption is flawed for two reasons: One, there are often very high costs for investors to switch between funds (including charges, dilution levies, and possibly capital gains tax), so they are not nearly as free to move their money in response to fee hikes as some might suppose. Second, it is often not the investor who is making the decision, but the adviser, who may or may not share their clients’ sensitivity to fees and may also be deterred by possible regulatory sanctions designed to prevent "churning".

Given all of this, it seems that the first step is to at least make fund operating costs as transparent as possible. This won’t solve every problem, but it will at least give investors access to the information they need to make informed decisions.