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Envy, desire and basis points


I would like to tell you a story. It’s one about the tempestuous relationship between fund managers and their investors, a tale of envy, desire and basis point negotiations. You may have spotted by now that this is not the plot for this season’s latest blockbuster. My story has recently gained a little extra spice with two old-fashioned heroes riding into view. One from the West – Omaha - and the other from the East - well, his father hailed from Russia – with both willing to make a little less money in order to help their fellow citizens. Warren Buffett and Stuart Rose are not alone; others in France and Germany are also saddling up. These horsemen seem to be heading in the opposite direction from those in the European funds industry. There is one aspect that I’d like to look at to explore this: the fees generated by funds in relation to their assets. And in this case Europe and the US look pretty different. One of the implicit benefits of investing in a mutual fund is that investors enjoy lower annual charges as a result of a fund’s success in increasing assets, in other words that costs fall as more investors join – economies of scale. The following chart illustrates these economies of scale in action for funds sold across Europe. But although the disproportionately high expenses borne by the smallest funds does mean that average total expense ratios (TERs) fall as assets rise, crucially, such economies of scale do not continue through further asset rises among larger funds.  View the chart by clicking here. ECONOMIES OF SCALE When comparing the UK to continental Europe there appears, at first, to be a different approach. But on closer scrutiny one can see that the apparent lack of economies of scale being passed on to investors largely reflect the fact that the smallest funds in the UK tend not to let expenses get out of control and create disproportionately high TERs. The more important issue, and one where one begins to question whether European or UK fund companies are acting in investors’ best interests, is that any economies of scale achieved for investment management fees are not passed on to retail investors.  This contrasts sharply with practice in the US. Click here to view the chart. Taking US large cap funds to illustrate this, the relationship between fund assets and management fees can be seen as an ‘n’-shape.  Management fees (excluding distribution fees, known as 12b-1 fees) are low when funds are smaller because the management company waives most of the fee. Then, as the fund grows, the company waives less so the average fee is higher.  Finally the fund reaches levels where real economies of scale kick in – and so-called ‘breakpoints’ are applied – so management fees drop again. In contrast to Europe, the rate of decline in average TERs increases as assets rise. However, it’s worth noting that many European managers would not want individual funds to reach the sizes commonly seen in the US – even if the companies they work for might see the appeal. IT’S A FIX But the story does not end there. One area that has barely been scrutinised in public is the growing practice of fixing TERs. Such moves have been trumpeted as a triumph for transparency – investors know what the annual operating costs borne by their funds will be every year. But the flipside to this is whether the motivation for such a practice is the interests of investors or the revenues of the fund company. The positive aspect of fixing the TER is that if assets fall dramatically, the TER will not rise.   Having said this, as many of the groups who take this approach are larger it is not unreasonable to assume that the fixed expenses have been set at levels the companies can afford. In this situation, the fund company earns management fees higher than the percentage quoted. In other words, if the operating expenses incurred (in sterling terms) are lower than the fixed percentage, then the remaining money is taken as revenue – not paid back to the investor.  So if a fund with a fixed TER of 1.65 percent, including a management fee of 1.5 percent, has assets of 100 million pounds and bears back-office costs of 100,000 pounds in one year, then the management fee revenue earned will be 1.55 million pounds (or 1.55 percent). The TER stays the same, so the client knows what costs his fund is bearing, but the fund company takes home a larger slice of the pie. Hmmm. One of the key drivers behind this transatlantic divide is the interpretation of fiduciary responsibility in relation to fees. Without such an interpretation in Europe, without regulations for anyone to act in this way, and without a compelling business case for companies to change this situation (which the Retail Distribution Review might bring about in the UK), then however logical it might seem that annual charges borne by investors should fall as fund assets rise, it is unlikely that they will do so. Meanwhile, Warren and Stuart ride off into the sunset, still paying the same tax.