Competition and technology should have forced down prices for investors
When, in 1931, M&G created the First British Fixed Trust, the UK’s – and indeed Europe’s – first unit trust, there were no Penguins. Penguins were first created in 1932. Yes, I was shocked too, until I realised that was the chocolate biscuit, not the tuxedo.
Nineteen-thirty-two was indeed a fine year for the delicious. Mars bars, Terry’s Chocolate Orange and Elizabeth Taylor were all born in that year. Branding aside, Penguins and the other sweeties are much the same as they were in 1932 apart from Liz, RIP.
They are, however, dramatically less expensive in real terms; Tesco has Penguin bars on offer at £1 for eight as we speak, so its price is less than a quarter what it would be (c. 97p per bar) if it had risen as fast as inflation. In 2018, I may not have the app-supported, social networking i-Penguin, but it’s still a tasty chocolate biscuit. And it’s cheaper.
One might imagine that advances in technology, manufacturing and operational efficiencies would have made most things cheaper today. When M&G began our love/hate relationship with active investment management, fees were fixed by the Board of Trade, with an initial charge of 3.25 per cent followed by an annual charge of 0.5 per cent (no trail back then, of course).
By 1938, there were around 100 funds, collectively worth just under £100m – £6.5bn in today’s money. The managers of those funds collected some £490,000 (£32m) in annual fees that year, versus average annual earnings of £112 (£7,270).
Today, around one in five people in the UK own shares and 16 million individuals own an investment product of some kind. They are serviced by a sophisticated retail investment industry where technology, data availability and retrieval capability have grown exponentially since 1931.
The investment management businesses in the UK control around £8trn, directly employing some 38,000 people and approaching 100,000 including related activities. The retail fund industry is worth at least £1trn and alone probably generates around £7bn in management fees.
However, it can be argued that, for the investor, nothing has changed in 86 years. New markets may have opened up fresh opportunities, but the risk premium – at least in Western markets – has seen no paradigm shift. More of investors’ money is now extracted in charges to support an information, administration and distribution structure that appears to have delivered no economies of scale.
The furore relating to closet-tracking has directed a spotlight on fund fees
There are approaching 3,000 funds in the UK and many thousands of share classes. Over 400 funds focus on the UK equity market (excluding smaller companies), essentially fishing in a pond of fewer than 700 companies (the FTSE All Share index), which constitutes 98 per cent of the total market capitalisation.
In any other industry, that much competition using a limited resource would have forced down prices or put the majority out of business. It hasn’t. Investors pay more today in annual charges for the same result.
The application of ad valorem fees assumes it requires more resource to manage a larger fund. On the other hand, segregated accounts (endowments, foundations etc.), pay tiered fees, reducing as the size of the investment grows.
If I have a UK equity fund that has around 100 stocks in it, do I warrant over £2m in fees for running it because it has £130m funds under management? Or £20m because it has £1.3bn in it? Or £200m for £13bn? Remember, the charge is irrespective of performance.
The furore relating to closet-tracking has directed a spotlight on fund fees and the cost of active management. I’ve written before about ‘active fee’, where the manager charges a fee in excess of 6 basis points proportionate to the fund’s active share. This creates a unit price for active management, with which competitors can be compared.
A more radical alternative is for all funds to link annual charges to the benchmark or index being followed. If the index doubles, the manager discounts half the fee back to the fund. The fee remains the same as it was in absolute terms. If the market falls by 50 per cent, the fee doubles – revenue stays the same.
Tracker funds would take more or less a constant, fixed fee, recognising there is no skill, and hence you’d get what you paid for. So how does the manager’s fee grow? By growing the fund in spite of the benchmark. They call it Alpha.
I’m sure there will be operational reasons presented why pricing models like this could never work and I doubt there will be a queue of fund managers desperate to implement them.
But the fact remains that there are too many funds, from too many undifferentiated businesses that purport to have a ‘unique investment proposition’, that frankly all do the same thing and cost customers more than they did nearly 90 years ago. That has to change and it is becoming a hugely challenging issue for the industry.
Innovation is required, as well as a refocus on the customers who buy them. The regulator has thrown down the gauntlet to the fund management industry and the next round of consultation won’t be satisfied with a cup of tea and a chocolate biscuit. Even if it is a Penguin.
Graham Bentley is managing director of gbi2