- Centre for Advanced Studies in Finance
The Financial Conduct Authority (FCA) has stated that there is an issue within the fund management industry of hidden costs and fees. Opaque costs and fees are problematic as they can be confusing and/or misleading for trustees making investment decisions, and can hide unreasonably high costs being unnecessarily incurred at the expense of the pension fund.
As a possible solution to make fund management costs more transparent, the FCA has argued in its Asset Management Market Study that costs and fees should be grouped as either explicit, such as management or performance fees, or implicit, such as custodian accounts (an account that an adult controls for a minor) or securities lending (loaning stocks to a firm or investor).
If this strategy is to work, it is crucial to understand whether trustees have a thorough knowledge of explicit and implicit costs and fees, and whether they are in a position to use this knowledge meaningfully when making investment decisions for the funds that they steward.
Partnering with Aon Hewitt – a leading global provider of investment consulting services and adviser to pension scheme decision-makers – I have worked with colleagues Drs Richard Hodgett and Simon McNair to undertake research exploring trustee investment decision-making. In our first report, which I have previously written about on the blog, I outlined the trustee landscape, providing a profile of the average trustee including their level of financial literacy. In this second report, we look at the prominence of costs and fees with respect to investment decision making and consider both the explicit and implicit fees associated with fund management.
Main findings from the research
Investment strategy is a primary concern for trustees, with costs and fees being considered afterwards.
A number of trustees from a range of different pension schemes were interviewed about a variety of issues. As part of this interview, trustees were asked “How important do you see costs and fees being in your investment decision-making, and what sort of discussions do you have around this?”
We received a range of comments, with the general view being that costs and fees are not the key to pension fund outcomes; for trustees this is achieved via strategy and asset allocation. Basing a decision on costs and fees comes second to the wider investment strategy.
There was also a view that it was not a trustee’s job to concern themselves with fees, as this should have been taken account of in the selection of fund managers. In other words, when the fund managers were hired to implement the investment strategy, their additional fees should have been considered then, rather than when trustees are devising the investment strategy.
Almost half of trustees choose active over passive management.
In our survey (which was completed by 197 trustees) respondents were given a simple choice of three different funds with only descriptions of the fund type. Trustees were asked to pick the best investment from a passive, low-cost index tracker (i.e. just following the market such as the FTSE 100), a balanced fund with 50% invested in bonds and 50% in an index tracker, or an actively managed equity portfolio (where a fund manager actively researches options and invests based on a number of different factors.)
The results showed that nearly half of trustees picked the actively-managed funds. It is the actively-managed funds, with their associated costs and fees, that have been singled out by the FCA as being opaque and the fees too high, relative to the returns generated.
Within the fund management industry there has been a significant amount of investment in the marketing of active fund management and its value. Underpinning this is the belief that managers can beat the market on a systematic basis and in doing so, add value over above a low cost tracker that merely follows the index. However, there is considerable evidence that the market cannot be systematically beaten after you take costs and fees into consideration.
The influence of investment consultant is not as strong as expected.
We also examined the impact of investment consultant recommendation. We presented the trustees with the same information on the performance and benchmark of certain funds, but added in a forward-looking consultant recommendation.
Our data showed that the investment consultant recommendation did not sway large numbers of respondents towards a particular fund, and although some movement was present, it did not result in a major reappraisal by the majority of trustees.
Trustees are generally good at understanding explicit net of fees analyses.
Our survey also looked at trustees’ understanding of net returns (i.e. the value of the investment once costs such as management and performance fees have been taken off.) Trustees were given a range of funds they could select, and were presented with gross five-year returns and various cost disclosures, including the total expense ratio and its components (i.e. the various explicit and implicit costs and fees broken down.)
The majority of our sample picked the best fund net of fees, indicating that trustees understand the basic net of fees calculations. However, we did find that trustees of smaller schemes did not perform as well on this set of questions.
Trustees in general are less familiar with implicit fees and this is worse for trustees of smaller schemes.
Trustees were asked to rank how familiar they were with terms relating to implicit costs and fees (such as bid-ask spread, single swinging price, and market-impact costs.) Some of the costs that were listed are the subject of much debate within the industry, as they arguably cannot be known with certainty. However, they can still lead to a cost being incurred by a pension fund. The question was not set to find out whether the costs were sensible or practical, but to find out whether trustees have an awareness of implicit costs and fees broadly defined. This is important, as it is likely that understanding implicit costs and fees is going to be something that is expected of trustees in the future.
The results showed that there is a lower level of familiarity with implicit compared to explicit costs and fees. Our data also showed that the level of familiarity across almost all fees is lower with trustees of smaller schemes.
It is worth nothing that any solution to investment hidden costs may have unintended consequences. For example, a full disclosure of implicit costs and fees may result in information overload and prevent effective decision-making. Similarly, there may be a fixation on ‘costs’ over ‘value’ and it is the combination of both that is crucial to effective investment in pension fund management.
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