Fund Fees and the Investor

by George Hatjoullis

If you have read your FT carefully you will be aware that funds must now offer you an Ongoing Charge Figure (OCF) as an indication of the cost of investing in the fund but that this figure does not include all costs incurred in running the fund.Neil Woodford of Woodford Investment Management proposes to fully disclose all costs on his flagship income fund which apparently came to 0.87% in 2015. This it seems is a big deal.

The FT also includes a neat interactive that allows you to see the impact of fees on performance. Other things being equal, higher fees reduce performance. The key is in the expression, ‘other things being equal’. This is a very strong assumption. It says that fees are typically independent of performance. People compare a fee of 2% with one of 0.5% and assume a 6% return and come up with unremarkable conclusion that you earn more with a lower fee. No sh*t sherlock.

Investors are not really interested in the fee. They are interested in the risk adjusted net return. If this were not so there would not be any active managers nor any hedge funds. The latter charge exorbitant fees and promise very high risk adjusted returns (aka alpha). It is a matter of heated debate whether either deliver what they promise but that is beside the point. You don’t have to invest with active managers or hedge funds. My point is that knowing the precise value of the fees incurred tells you nothing in itself about the ability of the fund to generate alpha. Fee transparency is neither necessary nor sufficient in understanding the potential for alpha. You can always use net historical return as the fees are embedded.

The focus on fee transparency is motivated by the assumption that alpha is an illusion. Fund managers as a collective cannot beat the ‘market’ (how could they?) and unless there exist consistent outperformers that can be identified ex ante, you may as well ‘buy the market’. In other words, opt for passive investment and look for the cheapest fund. Full disclosure then becomes interesting. There is a lot to be said for this approach. One invests in index tracking funds (the cheapest) and adjust portfolio risk by the proportion invested in different risk classes (bonds, cash, property etc). Of course, even trackers have tracking error and administration issues so simply buying the cheapest may not be the best policy.

The problem is in assessing ex ante portfolio risk. How do you know what risk you have and how do you achieve what risk you want (I shall ignore for the moment the fact that 99% of investors have no clue what risk they want)? This is far more important an issue than fee transparency. It should be noted that Woodford is a ‘star’ fund manager and became one when fees were very opaque indeed. Investors noted he was consistently outperforming (net of fees) and with a comfortable volatility (by definition). His success is evidence that fees are a red herring. What matters is net returns, ex ante risk and consistency.

One of the big problems is that investors do not know their own risk tolerance. Typically they are asked to scale themselves between no risk and high risk. The meaning of risk is not always made clear. It means drawdown or mark-to-market variation in the value of your portfolio. If you log on one day and have a heart attack because your portfolio value is 10% less than the amount you put in then you are a no risk investor. Don’t kid yourself. Unfortunately many investors do not realise their true risk profile until after they start investing. They then panic and take inconsistent and inappropriate action. Some psychometric work in this area might bear dividends for all concerned.

Once the risk profile is clear then investors must come to terms with the typical returns that are consistent with the level of risk. If you are a no risk investor then the long term government bond yield is about what you should expect. You can earn more but expect the value of your portfolio to vary more from day to day. The other problem can be selective performance focus. I once had a client that, despite record outperformance on the fund, insisted on looking at the components that performed poorly. He had not grasped the concept of a portfolio.

The focus on fees is more relevant to passive management for given tracking error and administration. In this case everyone is buying the ‘market’ so fees are a primary consideration. In the case of active or tailored management one is buying a service and should expect to pay for it. If the service criterion is risk adjusted net return then the fee is embedded. Transparency is neither necessary nor sufficient to indicate value for money.