Discerning between marketing and fact: fund fees and performance

As independent financial planners we are inundated with meeting requests from local and international asset managers. Ultimately, asset management is a highly competitive industry and the way every firm makes money is through fees. The more clients a fund signs on, the more assets under management grow, and the more the small (sometimes not so small) fees begin to add up for the manager.

Our task at Veritas is to select managers and funds that will produce outcomes that match the investment and lifestyle goals of our clients. This task is not easy, however rest assured that we take it seriously and we do our due diligence regularly. Sometimes we will change our minds about a fund or asset manager, but this is only when we are as sure as we can be, that it will benefit our clients.

In general, what we are looking for in an investment vehicle is outperformance at the lowest fees possible. We recently came across an interesting article that focused on the issue of fees, arguing that larger funds were overcharging their clients for performance and that smaller fund managers ought to be given a chance, because they were more nimble and able to change positions faster, to capture market trends.

In this newsletter, we would like to unpack the rationale behind this argument.  While we completely agree that performance fees can unnecessarily and unfairly reduce performance for clients and threaten their long-term goals, simply choosing between large and small asset managers and funds is not an either/or situation. It is a lot more complex than that.

The first contention of the writer was that fund fees in South Africa tend to be very high by global standards – we agree. Our view is that performance fees are unnecessary because performing is what you contract an asset manager to do. We are delighted any time the media shines a light on this practice, mostly because we feel it is unfair to allow every asset manager to select their own performance benchmarks. Instead, we believe that charging a competitive flat annual fee would be in the best interests of our clients.

In our opinion, the Financial Services Conduct Authority – the regulator of the asset management industry – which centres its regulations around the concept of Treating Customers Fairly – should stop this practice and set an industry standard benchmark. This would ensure that an impartial party setting the benchmark has the goals and investment outcomes of the customer in mind, rather than the profits of the asset manager.

Fees change frequently and can be complex both to identify and understand, but at Veritas we have been working to further drive down total costs for our clients. Because we do not have the scale of some non-independent industry advisors, our strategy is to use wholesalers to negotiate on our behalf – and, more importantly, on your behalf. We are getting there.

The article’s contention is correct: the asset manager fee across our global balanced portfolio is around 0.8%, which is significantly lower than what you would expect to pay a locally domiciled balanced fund – about 1.5% on average.

Now let us look at the related claims to assess their accuracy. The article claimed that fund size was a hindrance on performance, using the analogy that a large fund is like an oil tanker (slow and difficult to turn) while a small fund is like a speedboat.

We looked at the June 2022 Morningstar performance tables and chose funds with ten-year track records. All the large funds we selected for the comparison had been large for more than a decade, with the same going for the medium and small funds. Then we looked at their current annual fees and their annualised performance over the last ten years.

As you can see, the six largest funds gave an average annualised return of 9.4%. The performance of the ‘speedboats’, by comparison, was disappointing – effectively a 30% loss per year against the big boys.

We need to insert the disclaimer that we do not select funds based on their size and we are not automatically in favour of larger funds. We use smaller fund managers selectively within our diversified portfolios, with the objective of achieving risk-adjusted returns at lower overall cost.  The case for the agility of smaller managers’ is technically sound.

Large funds, however, do have a number of things going for them: firstly, they are managed by teams that have the capacity to take advantage of offshore investment opportunities.  Smaller asset managers rarely have the scale and ability to truly manage offshore positions well. In the context of a shrinking JSE, thanks to a stream of de-listings and corporate actions, this is a significant factor – particularly when the offshore allowance has now been raised to 45% within retirement funds and there is more potential to enhance performance through exposure to global assets.

Secondly, there is a significant risk involved in backing a small investment team that does not have a long track record of managing through economic cycles.

It is not uncommon for competitors to talk up their abilities, and we believe that a little digging into the facts reveals that there can be no blanket approach to linking smaller size, lower fees and performance. If we made decisions like that, we would not be doing our job in serving your interests.

We support entrepreneurs in this industry and we would love to see good competition driving fees lower, but we urge our clients to be careful when reading opinions like these – even if through seemingly trustworthy or respected media channels.