Lukasz de Pourbaix examines the natural tension between fees, investor outcomes and investment philosophy.
A key thematic impacting most parts of the wealth management industry in recent years has been the increased focus on fee disclosure and the ongoing downward pressure on fees across investment management fees, advice fees or platform fees.
Within the investment world, we have seen the regulator seek to provide clients with greater transparency around investment related fees in Product Disclosure Statements via RG 97, which has caused much debate in the industry.
The ongoing focus on fees in the industry is likely to continue from a regulatory perspective, which has led to the ongoing evolution of low cost product options entering the market. The managed account sector is no different, with various layers of fees involved depending on the managed account structure adopted.
Amidst this backdrop, there is a natural tension between fees, investor outcomes and investment philosophy, which warrant further exploration.
Fees
If we take the fees in a separately managed account structure (SMA) outside of platform and brokerage fees, the key fees relating to the investment structure include:
- the model management fee, which is the fee paid to the appointed entity managing the SMA portfolio;
- the underlying investment fees, which relate to the indirect cost ratios (ICR) for the underlying investment options used within the portfolios, such as managed funds and ETFs; and
- the responsible entity (RE) fee, where the RE plays the dual role of trustee and manager of the investment scheme.
Where a ‘private label’ solution has been developed (a tailored SMA solution specific to a financial planning dealer group), the model management fee may be split between the model manager and the respective financial planning dealer group offering the SMA. Under this fee construct, the fees will vary materially between SMA portfolios. The key variable being the fees associated with the underlying investment vehicles used.
In developing an SMA portfolio, it is common practice for a fee budget constraint to be in place limiting the aggregate underlying product investment management fees. This is particularly common for private label portfolios, where the dealer group is looking to manage the ‘all-in’ cost associated with investing in their SMA offering.
In my experience, the common rule of thumb investment fee figure used by financial planning dealer groups as a reference point as an ‘all-in’ investment cost is 1 per cent per annum. This fee comprises of the model manager fee, underlying investment fees and RE fee.
Fees vary across the industry depending on scale, portfolio structures and platform providers, but a sensible proxy for the fee breakdown is an RE fee of approximately 0.10 per cent per annum, a model management fee of circa 0.10 per cent per annum to 0.30 per cent per annum, leaving approximately 0.60 per cent to 0.80 per cent per annum to construct a diversified portfolio.
This does not include any margin the dealer group may look to generate under a private label structure, which would generally be incorporated within the model management fee.
Fee budget
In setting a fee budget, there are several things to consider.
A key consideration is whether the fee budget constraint allows the model manager enough scope to execute on the investment philosophy the manager has adopted and ultimately, whether the model manager will be able to achieve the portfolio objectives within the stated fee budget.
For example, if the investment philosophy states that the model manager believes in active management, then creating a portfolio largely consisting of passive strategies in order to reduce cost is not consistent with that investment philosophy.
Ultimately, the objective of setting the fee budget is to keep the model manager focused on executing the investment philosophy and investment objectives at a reasonable fee point, rather then constraining the portfolio to such a degree that the portfolio does not reflect the investment philosophy and investment objectives are not met.
In managing to a fee budget, there are two main levers model managers have at their disposal.
The first is to prioritise the areas where they are prepared to pay more and where they are comfortable to seek lower cost options.
Typically, this will be determined by identifying which sectors and investment strategies are deemed to be ‘high alpha’ segments or investments that offer a unique exposure to diversifying assets not accessible in lower cost structures. Examples may include long short equities, alternative strategies, active small caps and absolute return strategies.
Conversely, the model manager may seek lower cost options to access market beta, be it in the form of a passive market cap weighted index exposure or ‘smart beta’ approaches that seek to exploit a particular market factor, such a ‘quality’, ‘value’ or an equal weight approach to investment.
Interestingly, we have also seen some traditional active strategies reassess their fee model, recognising the downward pressure on fees in some asset classes by lowering their investment management fees.
The other increasingly common approach to managing investment fees is to negotiate fee rebates with fund managers.
Historically, the ability to negotiate fees with investment managers has been the domain of institutional clients, however, with the growth in managed accounts, we’ve seen an ‘institutionalisation’ of the wholesale space.
There are various approaches fund managers take towards fee rebates, ranging from managers not offering fee rebates, a tiered fee model based on scale, through to access to the institutional class of a fund.
The drivers for managers negotiating fees will vary significantly. Considerations such as fund capacity, scale, client servicing requirements, and where a product is in its product lifecycle, will all have an impact in manager fee negotiations.
From an investment perspective, the fundamental consideration in building a portfolio should be the quality of the underlying managers and the net of fee outcome for clients. Any fee rebate discussion should fall out of the process, rather than being a primary driver of manager selection decisions. The main situation to avoid is compromising quality for fee rebates, as over the long-term, it will ultimately compromise the overall portfolio outcomes for the client.
Ongoing focus
The ongoing focus on fees within our industry is unlikely to subside any time soon.
The main focus in constructing a managed account portfolio should be the consistent execution of the stated investment philosophy and achieving the investment objectives over the relevant investment time horizon.
The underlying investment management fees should be considered from the context of whether the relevant investment strategy is achieving the desired risk and return profile on a net of fee basis.
However, there are an increasing number of investment options that are available to portfolio constructors to assist in the management of fee budgets, and the growth in managed accounts has certainly seen the institutionalisation of the wholesale market with respect to the ability of negotiating fees with fund managers.
Lukasz de Pourbaix is Chief Investment Officer at Lonsec Investment Solutions.