Investment costs: who cares?
This article was first published in Citywire Wealth Management magazine for an industry audience. I have altered it only to make it more approachable for customers of the industry, who are, after all, the ones who will ultimately determine price levels.The total costs of investing for UK private clients are too high. We have analysed firms’ charges across most different business models (an audit of existing arrangements forms part of our investment planning for all new clients). We observe a bunching of all-in costs (excluding trading) between 1.4% and 2% pa, even for clients with multi-million pound portfolios. I am excluding entry charges for either products or services which also widely apply.
These costs have to be compared with mean expected portfolio real returns (at the typical risk level) of about 5% pa and a risk premium of 4%. In an economy in which most core services have become vastly more sensitive to price competition, the investment industry is holding out. It is different because it is better able to rely on the ignorance, inertia or resignation of customers. Ignorance is supported by opaque charging methods. Inertia results from unwillingness to engage with financial matters and a preference for blind trust and dependency. Resignation reflects scepticism about alternatives: ‘they are all as bad as each other’. In a marketplace dominated by ignorance, inertia and resignation, leakage of customers arises largely from opting out, or DIY. But this too has a barrier in the form of the time spent on the work otherwise laid off to agents. And so it goes on.Or does it?
There seems to be a real sense amongst different wealth management firms (privately, at least) that they are skating on thinner ice. No one is expecting the ice to break suddenly or soon; but there is an acceptance that it will. Why the change?RDR has made costs harder to hide RDR (the FSA’s unimaginatively-named Retail Distribution Review) was a set of new regulations intended, by removing biases that thrived on lack of transparency, to drive investors’ costs down; but it mainly affects the components of all-in costs, rather than the level. IFAs have to command a fee but can better do so if they are seen to be cutting product costs (hence so many Damascene conversions to passive management by firms previously philosophically wedded to active). Vertically-integrated managers can maintain margins by shifting more to own funds at the expense of open architecture.
But RDR also prompts conversations with all clients that would not otherwise have arisen and, as much as they try to keep them low-key* (read their websites to see how they trivialise RDR), they disturb the inertia.Attack from segmented businesses The asset-based fee model is redistributive: the largest clients subsidise the smallest, lowering the entry level and broadening the market segments a firm can profitably do business with. A firm serving a more narrowly-defined, homogenous segment can base fees more closely on economic costs without cross subsidy and undercut the equivalent fee rate in less segmented firms.Falling index-tracking costs The opportunity cost of active management is rising as new entrants to the ETF market (Vanguard) and post-RDR prices from existing providers (HSBC) attack the high margins of market leader iShares. It is putting pressure on index-tracking unit trusts but it also raises the bar for active fund managers.
Plausible alpha (expected risk-adjusted outperformance against a benchmark index) now has to overwhelm a pure product-charge difference in major markets of 0.75% pa (Total Expense Ratios for actively-managed funds averaging 0.90% pa versus 0.15% for passive vehicles). If all that selection activity is cut out, management fees can be set lower.Opting out is better supported The standardisation of the business format between firms with different origins (banks, stockbrokers, IFAs, boutique managers) has reduced the process of portfolio management to a common denominator that is easily replicated. Web-based businesses can perform (often with better tools) exactly the same functions:self-diagnosed risk assessment matching up to a standardised asset allocation on a risk spectrum defined by a single-period volatility measure performance-driven, active-manager screening and selection switching funds and rebalancing asset allocations.Cost savings of between 30% and 50% for the same functions on a guided-DIY site can be achieved – putting a very high price on the role of an agent or the time of the user. Further gains can be made by opting out of active funds, moving cost savings up to 75%.
Opting out of balanced management altogether, replacing a conventional rich mix of bonds and equity-based investments with a bar-bell strategy of cash plus globally-diversified equity exposure, could cut costs even further using the same platform, with no expected loss of economic value.TechnologyTechnology carries two threats to existing businesses:incumbents have notoriously inefficient systems supporting their factory-line, standardised processesnew entrants can go straight to technology-supported mass customisation.It opens up the possibility to model personal financial plans, making a clear, intuitive link between client-defined goals and constraints and the structure of their portfolios; tying resource planning to risk taking. It supports multiple risk metrics, instead of just volatility: inflation risk; horizon-specific outcomes; shortfall risk; sustainable draw or income.I forecast a radical reshaping of the routes by which private clients access capital markets, with more differentiation, lower costs and more useful and engaging services.
Predicting the pace is impossible: who knows where tipping points are when inertia has so firm a grip?*Survey research by MDRC published in October, so still before the RDR deadline, reported that 40% of high and ultra-high net worth individuals said their wealth managers had failed to explain the Retail Distribution Review changes to them (Citywire, 7th March 2013).