The Fee Conundrum: Are Mutual Funds Worth Their Fees?
On December 31, 2012 the FSA introduced the Retail Distribution Review (RDR) in the
UK. Early adopters Australia and the Netherlands followed not much later with restrictions on fees for retail investment products. More countries followed since. The common mindset of course is “establishing a resilient, effective and attractive retail investment market”. Bottom line: ensuring the interests of clients and their financial advisors are in line.
According to the FSA key elements of RDR are:
- Independent advice is truly independent and reflects investors’ needs
- People can clearly identify and understand the service being offered
- Commission-bias is removed from the system and recommendations made by advisors are not influenced by product providers
- Investors know upfront how much advice is going to cost and how they will pay for it
- All investment advisors will be qualified to a new, higher level, regarded as equivalent to the first year of a degree
My former Client
I remember well when a befriended client asked me how much he paid on average in kick back fees on his mutual funds. The client, a successful entrepreneur, expected it to be an easy answer but noticed from my reaction I didn’t have those figures readily available. As with most investment advisors to High Net Worth Individuals my firm handed me a package of headline information of my client base, which in most cases was overly sufficient when liaising with clients. Kick back fees weren’t included as you were discouraged to touch on this sensitive subject.
From his entrepreneurial point of view however, it was probably one of the most logical things to ask. Why should this matter to you as an investor nowadays, with the regulatory landscape already changed for the better? For one, because focusing on costs is still far more important than you think in the long run.
Lets start by agreeing that an investment advisor or consultant should possess superior knowledge of investment products and financial markets to serve his clients well. After all, he should add a decent amount of value in the end. Especially because it seems normal to assume this service comes at a certain price, I was baffled to find most clients outraged when the new regulatory rules forced the banks and independent advisors to redesign their revenue models and charge clients directly. It was the first time most clients actually saw the price tag of the investments services offered to them.
Lets focus on mutual funds
Now lets focus on mutual funds for now. Even with retrocessions banned and the fee your financial advisor charges you for his services aside, you are still paying a management fee to the funds you hold in your portfolio. Just visualize a room full of investment analysts, traders, one or more fund managers and the likes. Add to their paychecks the cost of a state of the art infrastructure, prime location rent and so forth, and you get a rough idea of what the costs are to run a mutual fund.
If these funds have a high probability to beat the market after extracting the costs, in general, the funds are worth their penny. Sadly, empirical evidence suggests very few mutual funds in the retail space have actually managed to outperform the market consistently over the years. After fees, that is.
On the selection side a simple but rather intuitive theory says it’s hard to beat the most liquid markets due to informational efficiency. A blue chip company may be covered by 40 or more analysts with company information widely available and disseminated with the utmost care. Without digging too deep in the world of sell side analysts, most analysts will be in close vicinity to analysts' average opinion. When I met clients in our Amsterdam office, I frequently used the city theatre across the street as an example: the privately held company doesn’t have to comply with public market reporting standards.
WHAT SHOULD YOU DO?
Try digging up useful information on that company!
With all this in mind, considering a mutual fund covering the most liquid of markets quite often seems like gambling with poor odds. From this perspective there is a lot to gain by selectively adding ETF’s to your portfolio. perspective there is a lot to gain by selectively adding ETF’s to your portfolio.