For decades, investors have obsessed over the notion of “beating the market” or finding the best fund managers who can. In industry marketing jargon, this is called generating “alpha”.
There is however no fancy Greek term for the high fees you pay for this privilege.
The word ”alpha” has been used verbally or in written form, some orders of magnitude more than what has actually been generated for clients, since the concept was coined in the 1960’s.
The incredible shrinking Alpha
Alpha has become very scarce, compared to decades ago when markets were perhaps less efficient; less transparent, less regulated and there were fewer players and products. Nowadays the revolution to index / passive investing has taken hold – more so in the USA and UK, but is gaining in popularity in South Africa. It has taken about 70 years for this phenomenon to become mainstream.
The father of index/passive investing, the late John Bogle, who founded what is now the 2nd largest global fund manager – Vanguard, wrote his senior thesis making the case for indexing way back in 1951. He argued that alpha or beating the market, eludes most investors – certainly after costs.
In South Africa, active fund management is still quite strongly the dominant belief of the majority of the industry, But, things are changing, as constant evidence builds, showing that the majority of fund managers cannot consistently beat the market.
How much are you really paying?
You are not paying for Alpha – you are paying on the chance you’ll receive it!
What is the cost you are bearing for this possible outcome?
In a time of low total returns, this is a question increasingly on the minds of investors and in particular trustees, who are the custodians of employees’ retirement monies.
Today, fund performance data is ubiquitous. It can be found in industry performance surveys and also fund fact sheets. And, it constantly gets trumpeted by providers when they do well, to entice investors to support their products.
But what about costs data? To be fair, today there is a lot more information and transparency of investment costs data, but only because the regulator has forced the industry in this direction. This is mostly in the format of individual products, but there is very little in the way of industry; asset class or fund classification data, such as fee averages and fee ranges – to enable better benchmarking of fees. And, how and when data on investment costs are disclosed varies greatly. Often, what is disclosed, doesn’t actually mean much to those paying for it!
What is needed is more education around costs and better representation and comparisons, to enable more informed decision-making by trustees; advisors and investors themselves.
Who has gone further on costs – the retail or institutional market?
In South Africa, the retail investment industry has arguably lead with standardisation of cost reporting in the form of disclosing total expense ratios (TER) and total investment costs (TIC). They have also, for years, reported investment performance net of investment costs. One of the reasons this has been easier to achieve is that almost exclusively the retail industry is productised. On the other hand, the institutional market (retirement funds) is much less transparent and standardised. The industry still reports gross performance (ie. before fees) and trustees have a hard time collecting data on all costs, and then trying to understand what it all means.
Developments such as the Cost Transparency Initiative (CTI) in the UK go a long way to making progress. The CTI was an independent group tasked by the UK Financial Conduct Authority in 2018 to deliver a standardised template for the disclosure of costs and charges to institutional investors.
Even with such developments, the challenge remains – how to easily collect and analyse cost data, so that it can be assessed.
To this end, the formation of fintech company, ClearGlass Analytics in 2018, by Dr Chris Sier, who ran the CTI project for the FCA, has been a means to assist institutional investors, such a retirement funds, to collect detailed costs data and start to better understand all of their investments costs.
Cost benchmarking
Services such as ClearGlass are now shining a stronger light on costs and enabling better understanding of what is being paid and where. For example, do passive or active equity mandates produce higher transactions costs? In the sample of 2019 data analysed by ClearGlass which covered ~2500 mandates from ~200 pension funds, the evidence showed passive funds having lower transaction costs than active funds. Looking even further into the data showed a typically low quantum of 5bp for passive fuds with infrequent larger spikes, as compared to active funds which tended to have a much higher average of about 20bp, with some even going as high as 60bp.
At a total cost level for the sample, the mean distribution across cost categories showed annual management fees to be 61% of total costs. This means that up to 39% of costs are incurred elsewhere and if a fund is only assessing management fees, a substantial portion of total cost is being ignored.
You can’t manage what you don’t measure’ is a phrase much quoted by Dr Sier, who believes in getting into the detail of cost data.
We don’t yet have this level of data and transparency in South Africa.
Funds that spend even a mere fraction of their time on better understanding and managing costs, as they do on trying to find the elusive alpha, will yield guaranteed benefits, which will translate into more money in the pockets of fund members.