Small business owner Brian Taylor learnt a costly lesson on asset-based fees.Photo: Tamara Dean
Percentage fees charged by fund managers can be a lazy way to riches - for fund managers that is, not investors.
The percentage fees charged by fund managers keep coming out of investors' capital regardless of the direction of markets. What's worse for investors is that it keeps coming out even if the fund manager loses more money during market downturns than the market itself.
According to a report from the Australian Institute of Superannuation Trustees, percentage fees end up rewarding fund managers for accumulating funds under management, not necessarily for producing good returns. The study, which mostly concerned Australian shares, recommended super funds move to a fixed dollar fee plus a performance fee when negotiating fees with active managers of share funds.
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At the time of the release of the report in September, the institute's chief executive, Fiona Reynolds, said: ''We need a fee model that does more than reward fund managers for managing an ever-expanding pool of assets, even when they have not contributed to that growth. In a compulsory system where you have legislated growth of 9 per cent, this is a licence to print money.
''If we are serious about reducing costs across the super sector, we can't ignore investment fees.''
Investment markets rise and fall and fund managers cannot be held responsible for that. But the way they are paid has a big bearing on how well investors will do. Generally, investors will be better off with managers who are paid for performance, provided the performance fee is well structured.
Asset-based fees compound over time, just like interest on an investment. It's what the managing director of managed funds discount broker 2020 Directinvest, Michael Lannon, calls the ''reverse miracle of compound fees''.
Take fairly typical total fees of 2 per cent a year for a small investor and assume an investment return of 7 per cent a year. Lannon says that over five years, 7.3 per cent of the investment return will be paid in fees; over 10 years it's 17.2 per cent and 31.5 per cent over 20 years.
TAX EFFICIENCY
The tax efficiency of fund managers is also receiving attention from superannuation fund trustees. Fund managers who ''churn'' their portfolio increase taxes for investors compared with those managers who buy and sell shares with less frequency.
The returns and fees of managed funds are mostly reported on a pre-tax basis rather than after-tax returns. Two managed funds with the same gross return could have very different after-tax returns - the returns that investors actually receive in their hands.
Last year, the health and community services industry fund, HESTA, required the Australian share-fund managers it hires to manage the money in a way that maximises after-tax returns. Simple steps can be taken by managers to increase the tax efficiency of their funds, such as making better use of franking credits, holding on to shares for longer to take advantage of discounted capital gains tax and decreasing the frequency of share trades.
HESTA expected the move would add tens of millions of dollars to the value of its Australian share portfolio by measuring and paying fund managers on their after-tax performance.
More managed funds have performance fees but they tend to be boutique managers who believe they can outperform the market. Performance fees are also found among managers investing in market sectors, such as small companies, where there is the potential for large ''excess'' returns over and above market returns.
Typically, funds that have a performance fee will also have a ''base'' fee - the usual asset-based fee. Usually, the performance fee will be a percentage of the returns above the market returns. Investors should be paying a base fee that is less than the base fee charged by funds without performance fees. A performance fee should not be triggered until a fund manager has recovered earlier losses.
Key points
* Asset-based fees eat into returns because of the compounding effect.
* Asset-based fees can be ''lazy'' income for fund managers.
* Performance fees may be better for investors.
* Fund managers who ''churn'' their portfolios increase tax costs for their unit holders.
Anger over asset fees
Brian Taylor runs a successful small business and had about $1 million that he wanted to perform better than it could as cash.
Five years ago, on the advice of an IPAC Securities financial planner, he invested the money mostly in two balanced funds that would increase the capital by more than inflation without taking on too much risk. He enjoyed almost a year of good returns before the global financial crisis hit. He is naturally disappointed in the performance of his investment and understands the role of the GFC in most of the poor returns but says the investments did not perform as well as he was led to believe.
What infuriates him is the amount he has paid in fees and tax. He redeemed his money and ended his relationship with IPAC in July.
Based on the fees stated in his original statement of advice, Taylor estimates that he has paid about $86,000 in fees - about 10 per cent of his original capital - during the five years that he was with IPAC. He also had to pay a tax bill on his investments of $35,000 in one year.
Taylor has been in repeated contact with IPAC Securities and its parent, AXA, asking for a refund of fees and for a return of the capital that he started with and the tax bill he paid.
Both IPAC Securities and AXA reviewed his complaint and have written to him to say that they are satisfied that he was not misled. They say the advice was sound and relatively conservative; that all fees and charges were clearly disclosed and the investment risks explained.
Taylor says it has been a costly lesson of how asset-based fees compound over time and take capital away.
''These percentage-fees-on-assets for no performance have been the real killer for me,'' Taylor says.
And rather than paying asset-based fees, he says, in retrospect, he should have paid fees that were based on performance.
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