I listened to an advertisement from a financial services company recently. The reassuring voice over states “we don’t charge you until we have first made you a return of….” In other words, there are no initial fees on the product. This sounds very attractive, and judging from the sales numbers, investors are buying this hook line and sinker. However, I recently met an investor who bought into the product when it was first launched in 2012/2013. He was decidedly unimpressed with the investment. His portfolio would have returned over 50% since he invested his money, but because of the fee structure, he only got a return of below 40%. He would have been better off paying the initial fee instead.
Many investors are attracted to investments where there are no initial fees. This is because there is this belief that all their money will be earning a return, and because they do not believe that the adviser has done enough to earn a fee. I can sympathise with this belief, too many advisers sell product and do not offer proper advice. In order to offer proper advice to a client the adviser has to collect a lot of information from the client and do a thorough analysis. Any advice will then be based on the findings of that analysis. Clients can pay for that because they can see what work the adviser has done. In the case of a product sale however, there is not much work besides the preparation of some paperwork, and clients are correct in not wanting to pay for that.
Back to the issue of zero initial fees; many investors believe that they will earn a higher return if they pay no fees upfront, and if the adviser earns a higher ongoing fee instead. I attended an adviser function where an established adviser stated that his fee was 0% initial and 1% ongoing, no negotiation. When I challenged him on the suitability of this fee structure for clients, he was adamant that it was the best approach for them as well. He had built up a large asset base with this approach so he felt that clients were also happy with it.
What do the numbers say?
The issue of higher ongoing fees is relevant to advice fees as well as asset management fees. It is the total ongoing fees that matter most in the long run. Consider three scenarios; one with maximum initial fees and standard annual fees, another with a discounted initial and annual fee, and one with no initial fee but the maximum annual fee. Assume that the funds are invested in the same portfolio.
Over the 15 year term, it is the portfolio with the maximum initial fee that delivers the best return to clients, despite having the lowest net investment amount. The scenario with the lowest fund value was the one with the highest annual fee, despite there being no initial fee. These results are consistently the same from 7 years and longer. Below 7 years and it is better to opt for no initial fee.
The reason the scenario with the lower annual fee outperforms is because of the effect of compounding higher returns net of fees. So even though it starts off with the lower initial investment, it is compounding at a higher rate. Over time that compounding effect becomes the greatest contributor to portfolio value. The high initial fee represents a once off transaction; the compounding effect has the greatest impact over time. This makes the fee structure critical for long term investments such as living annuities and retirement annuities.
What fees do clients incur in an investment portfolio?
There are three distinct fees that a client pays when investing via an adviser; Advice fees, Administration fees, and Asset Management fees.
Advice fees: these are paid to the financial adviser. There may be an upfront fee as well as an annual fee. This fee should be to cover the cost of the advice process, portfolio structuring, ongoing monitoring and servicing.
Administration fees: these are sometimes referred to as product fees. Typically they are for fund aggregation, pricing, statements, tax certificates, reporting, and online access functionality. Most of the time there is only an annual administration fee, no initial fee.
Asset Management fees: these are also usually annual fees and cover the cost of asset allocation, stock analysis, stock selection, portfolio optimisation, risk management, compliance and reporting. There are also ancillary fees such as trading costs, auditing fees, bank charges, etc that have to be covered. Some managers have a performance based fee, while many opt for a flat fee. The total fee is reflected in the total expense ratio (TER).
In order for an investor to be successful over the long term it is important that they understand what fees they are paying, and what they should be receiving for those fees. Some companies offer all three components, advice, administration and asset management. As a result they are able to shift fees around, and give the impression that they are cheap. As an investor it is entirely appropriate that you interrogate those fee structures, and ask for clarity on expected total fees.
How do we mitigate fees for clients?
We do a number of things when it comes to fees and our client portfolios. From an advice perspective we charge an initial fee and look to moderate annual fees. In many instances clients have insisted on not paying an initial despite our best efforts to convince them that it is in their best interest over time. We then charge the higher ongoing. What we then look to do is reduce administration and asset management fees as far as possible.
With regards to administration fees, we chose the cheapest product provider. The investment amount can impact on the choice of product provider as some providers have a sliding scale that makes them cheaper for larger amounts. Our clients pay around 0.25% per annum for this.
The area where we can have the most impact is around asset management fees. Here we do a number of things; we blend passively managed funds into portfolios, we favour funds with low and flat fee structures, and we cap exposure to funds that charge performance based fees. We find that asset management fees tend to be between 0.60% and 0.80% per annum, which are highly competitive for retail investments.
It is important that clients understand what they pay, and what they should be getting for their money. If they are uncertain about any aspect then they should be persistent in seeking clarity, especially for long term investments where high fees can lead to low returns, and a poor investment outcome.