Author: Tom Wiseman, Managing Director, Enhance London
The total cost of investing is a topic de jour for financial regulatory bodies, and rightly so. It is important for investors to have a proper understanding of the management and operating costs associated with an investment arrangement. However, despite increased industry transparency and the disclosure of an Ongoing Charges Figure (OCF) within investment illustrations, I am yet to come across a common methodology for calculating the total cost of a managed portfolio for private investors that cuts the mustard.
Managed portfolio costs are the sum of numerous moving parts at a particular point in time that cannot all be accurately and reliably estimated. Trading commissions, SDRT and bid-offer spreads are obvious omissions from quoted OCFs, as are performance fees and costs arising by virtue of a client’s individual tax position and investment preferences – the list goes on. Historically, investors were given a ‘Total Expense Ratio’ as a reference point, but this had an equally limited and opaque methodology that delivered neither a ratio nor a comprehensive breakdown of total expenses.
So, what are private investors to do? Understanding the cost of an investment arrangement is a relevant consideration in portfolio manager selection, given that costs are the first hurdle any manager must overcome to deliver positive performance. However, simply hunting down the lowest cost provider using any common methodology in no way guarantees better future performance to the investor. Some investment processes, such as those constructed using actively managed funds, are unavoidably more expensive than others but nevertheless have merit. Some managers will charge a premium fee simply because they are demonstrably better than their peers from a performance or service perspective.
For these reasons ‘Price’ is the last point we consider in our manager selection process, despite the growing industry trend to initially screen investment arrangements by cost. We would argue that this is lazy advice. Not least because cost calculation is so varied and very often used by intermediated advisers as a means to justify investing clients in an arrangement in which their own advice fee can be best preserved. The trend of IFAs switching clients into low cost and simple model portfolios on platforms from more sophisticated managed portfolios is a good example of this.
Rather than focussing on cost, at Enhance we identify suitable portfolio managers from our research universe by first assessing past ‘Performance’ on a net basis along with each firm’s investment/operational ‘Process’ and its ‘People’. This ensures that the managers we shortlist have a demonstrable track record of delivering to the mandate in question after their costs. Our assessment also ensures the firm has infrastructure and talent in place that increases the likelihood of past performance pedigree being repeated in future. We then interview all managers on our shortlist before addressing the matter of ‘Price’ with them.
Having assessed ‘Performance’, ‘Process’ and ‘People’ comprehensively, we are less concerned about total costs, as the additional expenses incurred over and above the annual management charge are necessary costs to access each firm’s investment philosophy (although we always evaluate and fully disclose.) Instead, we focus very specifically on the annual management charge proposed i.e. what will our client be paying each manager directly for their expertise? This may also include trading commissions levied. On segregated managed arrangements, particularly, this is an area of overall cost that can generally be negotiated. It is difficult for managers to justify higher annual management charges than their peers unless they are truly outstanding in one way or another and this therefore gives clients leverage and leads to a competitive devaluation of fees.
This said, we are cognisant of that fact that the portfolio managers we work with need to be adequately compensated and incentivised should they be employed. Therefore, whilst we squeeze annual management charges, we do not aim to do so to the extent that the cost savings secured may lead to lower levels of diligence and service from the manager. In our experience clients are more than happy to pay a fair fee for good advice and service, and for a long-term relationship to flourish between all parties. For this to be possible there cannot be unsustainably low fee agreements in place.
Advisers that focus purely on the cost of everything will very often understand the value of nothing.
For more information on Enhance Investment Consultancy’s manager selection process, please see here: http://www.enhancegroup.co.uk/our-process