There has been some recent press about the launch of Fundsmith, my new fund management venture.
Since the press was generated by a leak, there has been much speculation about what features Fundsmith will offer investors. One area of focus of this has been on fees.
Without confirming or denying that fees will be a main area of focus for Fundsmith (we’d like to keep at least some secrets back for the launch) I thought it might provide a flavour of things to come if I comment on some problems with the structure of fees (and costs) which investors in funds currently experience.
A lot has been written about fund management fees recently, particularly with regard to the impact of the Retail Distribution Review (“RDR”). This comes into effect at the end of 2012 and will thereafter prevent advisers (IFAs, wealth managers and private client stockbrokers) from obtaining payment of part of the egregious upfront fees of up to 5% of the sum invested charged by many fund managers and/or “trail” commission paid from the annual charges levied by managers.
From 2012, advisers will need to obtain payment via advisory fees charged direct to the clients, which may prove somewhat harder to justify when they are explicitly charged to the client rather than paid by the fund manger after he has extracted them from the client’s investment.
What few people seem to realise is that trail commissions will still be paid to advisors on investments in funds made by clients in 2012 and earlier. This presents an obvious problem. We are told (“Serious Money: Take my (free) advice and avoid a haymaking IFA” by Alice Ross, Financial Times, 27th August 2010) that the FSA is monitoring turnover in fund holdings to try to spot any “churning” which may be caused prior to the end of 2012 by advisers getting their clients to invest in funds which will still pay a trail thereafter.
This leaves a rather more pernicious danger which needs to be watched for: the absence of turnover in those funds after 2012. Whilst activity is something which is correctly seen as the enemy of a good investment performance, it would be unsurprising if, having got their clients into trail paying funds prior to 2013, a lot of advisers weren’t suddenly seized by inactivity. This needs to be guarded against as much as churning.
Two and twenty
Two and twenty is the standard fee formula for the hedge fund industry.
It is unsupportable.
I am not so much shocked as flabbergasted by the number of people who do not realise the impact of these performance fee structures. I am not talking here about the fact that such a performance fee structure clearly led many fund managers to gear up their funds as much as the credit bubble allowed and place bets which many attendees at Las Vegas would regard as outrageous, knowing that they had little or no downside and 20%+ of the upside.
I have had discussions with numerous professionals in sophisticated jobs in the investment industry who are either unaware of or disbelieve the mathematics of what I am about to demonstrate.
As you are aware, Warren Buffett has produced a stellar investment performance over the past 45 years, compounding returns at 20.46% pa. If you had invested $1,000 in the shares of Berkshire Hathaway when Buffett began running it in 1965, by the end of 2009 your investment would have been worth $4.3m.
However, if instead of running Berkshire Hathaway as a company in which he co-invests with you, Buffett had set it up as a hedge fund and charged 2% of the value of the funds as an annual fee plus 20% of any gains, of that $4.3m, $4.0m would belong to him as manager and only $300,000 would belong to you, the investor. And this is the result you would get if your hedge fund manager had equalled Warren Buffett’s performance. Believe me, he or she won’t.
Two and twenty does not work. That does not mean that 1.5% and 15% is OK, or even 1% and 10%. Performance fees do not work. They extract too much of the return and encourage risky behaviour. The only way to focus your fund manager on performance without gifting him or her most of your returns is to ensure they he or she invests a major portion of their net worth alongside you in the fund and on exactly the same terms.
TERs and costs
There is a justified focus on the Total Expense Ratio (“TER”) of funds which include those expenses which the manager charges to the fund rather than simply on the fund management fee. However, there is one major cost that is not charged to the funds-the cost of dealing in the underlying investments.
This is not insignificant given that, according to FSA research, the average fund manager in the UK turns over their fund 80% per annum. This adds three layers of additional costs: 1. The commissions charged by brokers and investment banks for dealing; 2. The difference between the bid-offer spread for securities sold and bought; and 3. The fact that no fund manager has sufficient good investment ideas to warrant buying and selling 80% of your investment portfolio per annum.
Soon we shall see what Fundsmith can do about all this…….