Breaking down the detail of charity investment management charges
Just how relevant to charities is the debate about fund managers' charges - are there hidden benefits to charities which are not precisely charged for, e.g. administration, including sudden demands by charities?
St Luke points out in his gospel that “the labourer is worthy of his hire” but how can trustees be sure about what they are actually paying for and if what they are paying is fair and reasonable?
In this article, I will look at the pros and cons of all-inclusive fees against a clearer and more transparent breakdown of costs. Recent developments, such as MIFID II, have given us an opportunity to compare both approaches as investment managers begin the transition to greater disclosure.
There has long been debate about investment management fees. Are they too high? Should trustees focus on returns rather than the cost of generating them? In light of this new and more transparent environment we are arguably now in a better position to answer these crucial questions.
The first question, whether investment management fees are too high, has oddly enough been the most difficult to answer in the past. Most investment managers have charged an all-inclusive fee. This meant it covered a myriad of expenses such as dealing, reporting, monitoring and custody, as well as investment management. The result was that it was often impossible to determine how the fee was made up and what was being paid for administration, and what was for investment flair or talent and performance.
Cost of each element
This was important because, without transparency about how fees are made up, trustees could not know what each element was costing nor determine whether they were getting good value. If they knew what they were spending on just investment management, for example, they could evaluate that against the investment manager’s performance against their charity’s own return target. But if the fee includes a whole lot of other important services, the calculation would be more difficult and less relevant.
The argument for this approach was that this meant trustees were getting hidden benefits for a fixed fee, rather than facing a range of charges based (as they would be in the case of other professionals) on a “time spent” basis. Also those trustees who needed significant administrative time or detailed reporting could receive it without a prohibitive cost. It therefore helped prevent the creation of a two tier “playing field” with all trustees having access to many of the same benefits.
This has meant larger clients inevitably subsidised smaller clients and that there was little finance directors or treasurers could do to reduce fees charged by investment managers which included services they did not need or use because the fee charged was not transparent. A little like all inclusive banking packages!
It also meant that trustees could not judge whether using an external custodian would offer better value than using their investment mangers’ services. This could be important particularly where a charity had more than one manager but might want to administer its assets as one entity with custody being separate from either organisation. Unbundling costs into their various components in these circumstances would have enabled trustees to decide what parts they might outsource and therefore which areas investment managers might not then charge for.
Important step forward
Fortunately for us all, recent developments have helped to partially resolve this issue. MIFID II is an important step forward. Under its costs and charges disclosure rules firms are required to give clients information on all costs and associated charges in good time before they provide the relevant service to the client.
This includes both the investment manager’s explicit charges and all other costs and charges associated with the portfolio. Other costs and charges will include taxes, investment fund entry and exit charges and ongoing charges of investment funds and trusts (OCFs – ongoing charges figures). However, administration, custody and reporting still do not need to be specifically detailed.
Whilst this is an improvement and provides more detail, there is no standard form of disclosure. Therefore, getting a detailed breakdown of specific costs can be difficult and making comparisons can be difficult. As trustees it is important to be able to compare “like with like” and to draw a proper comparison. It is therefore important that trustees seek to ensure that as regulation develops further a standard format giving the greatest possible transparency develops. An important part of this is demanding as much transparency as possible from our own investment manager.
Identifying when VAT is payable
Another issue is tax. One of the few taxes charities are liable for is VAT. However, trustees will necessarily not want to spend more in tax than they need to. Those investment managers who want to ensure their clients pay the correct level of VAT should split out administration expenses from investment management fees. Administration fees do not attract VAT, whilst investment management fees do.
So, by splitting the fee into its component parts investment managers ensure that their clients pay only the amount of VAT due. Those who still parcel their fees together will end up having to charge VAT on the whole sum and therefore their clients will end up paying more VAT than they would if the fee was more transparent. It is worth asking why an investment manager would want a charity to pay more tax than is strictly necessary.
The current position is an improvement but it is still difficult for trustees to identify the costs relating to each element of the service they receive and establish if they are getting good or fair value for what they pay.
However, does this matter?
There are those who point out that “nit picking” about fees and how they are made up is a case of “not seeing the wood for the trees”. What ultimately matters, they argue, is what your return is after expenses. If low charges result in a poor performance, they are no saving at all. If we want the best investment management available, we should be happy to pay for it.
Their point is exactly the same as St Luke’s. The value of people is in what they do not the cost of it. Hence, we should judge investment managers on what they achieve not what they cost.
They argue that a fee difference of 0.25% per annum is insignificant compared to a statistically more important performance difference of 1% or more after fees. Even if you view investment management as a commodity with little differentiation, performance differences are likely to be bigger than fee differences.
Drag on overall return
I would take issue with such an approach. I would accept that that much of the debate on fees has been misdirected. The quantum matters in the sense that it is a drag on overall return but paying people by their results seems the right course to follow. We can only do this if we know what we are paying for.
Therefore, even if it is right that cost is not the best basis on which to appoint our investment managers (and I don’t agree it is) it is not an argument against transparency. The quantum may or may not be relevant but why we should we not know how it is made up.
Is there something special about investment management costs that mean they should not be viewed and reviewed in the same way charities review other costs? Is there any other area of cost where charities are equally indifferent about what they are actually paying for?
The real issue with fees is that trustees don’t know what they are paying for. In setting their fees investment managers know what their costs are and are unlikely to agree a fee which leaves them out of pocket, yet few are happy to disclose what those costs are.
It is difficult to understand the rationale behind this. If investment managers have the figures they should be transparent about them and share them with their clients.
Trustees might be concerned at the amount spent on administration or that they are not only paying for services they use but also for services used by others. They might be happy to subsidise smaller charities but they should surely know if that is what they are doing.
Knowing good value
Without answers to these questions they cannot also know if they are getting good value for money. So they need to encourage investment managers commit to transparency and be as clear as possible about how their fees are made up.
In this trustees have an unlikely ally in the HMRC VAT office. Those who split their administration fees from their investment management fees have to justify the non-taxable administrative element to HMRC. This means it has to be backed by evidence.
The best advice to trustees is that transparency is important in any professional relationship and enables you to do your job. Therefore, trustees should seek to get clarity about what they are actually paying for. If your investment manager cannot give you that clarity it may be more of an issue than what he actually charges you in total.