Finweek English Edition - October 24, 2019

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Investment costs – small today, but...

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i

nvestors are often cautioned that high fees and costs can be

detrimental to investment performance. Every investment comes

at a cost, but are higher investment management costs really an

indicator of better management skill and performance?

Many financial service providers use this explanation to justify fees

on their products – that you get what you pay for in terms of the skill and

knowledge needed to manage investments on your behalf. But published

fund performance data for equity funds in South Africa will show that the

correlation between fees and performance doesn’t always exist. So, what

level of fees and costs are reasonable in exchange for a strong brand?

And how much is simply too much?

“Part of the problem in answering these questions is that not all fee

structures are transparent or match what is claimed at the point of the

initial investment. For example, some managers charge a performance

fee even when markets are performing poorly,” says Terence Gregory,

CEO of financial services group Ecsponent Ltd.

Managers who limit the downside in a bear market to protect

investors’ capital should undoubtedly be rewarded. However, a

benchmark of 3% and actual fund achievement of 4% in a bad year,

could sometimes see a 20% performance fee being charged on the

1 percentage point performance above the benchmark. And

that is often levied before administration and annual

management fees have even been added.

The result for investors will be investment

performance far below inflation and inconsistent with

the funds’ claimed performance. The real investment

value is further eroded through inflation, which means

that investors are eroding wealth instead of building it.

“Fees can also be hidden and difficult to calculate,

especially in fund-of-funds structures, so that many

investors will not even know they are paying certain

fees. While each fee levied may be small in itself, over time

the cumulative effects of these layers of fees can become

significant. Just as investment returns can do wonders with

the effects of compounding, so fees can destroy capital through small

percentages,” says Gregory.

Using another example to illustrate, consider two individuals who

invest R500 000 into two different unit trusts on the same day. If

both funds appreciate by 10% per year before costs, but one person

is paying a total annual cost of 3% and the other 1%, after 30 years

the first investment will be worth R3.8m while the second would be

worth R6.3m.

“That’s a 42% difference in value, or R2.5m. Never has a 2% difference

looked so big. This is why at Ecsponent our philosophy is to keep costs as

low as possible,” Gregory says.

But what are these fees for in the first place? A typical unit trust

investment can incur three types of costs: financial adviser fees,

administrative or platform fees and investment manager or product fees.

The first type of fee is for performing, drafting and implementing

a financial needs analysis, for selecting an investment manager,

portfolio construction and performance monitoring.

On average, financial advisers charge a once-off fee for the initial

work to define an investment strategy and financial plan, and 0.5% to

1% as an annual advisory fee.

Administrative or platform fees are charged in relation to a

Linked Investment Service Provider (LISP). LISPs charge annual

administration fees expressed as a percentage of the assets

they manage on a client’s behalf. On average, LISPs charge

a minimum annual administration fee of 0.5%, but it can

in some instances be as low as 0.1%.

Investment management fees are typically charged

annually as a percentage of managed assets, for the

day-to-day management of the investment or fund.

On average, a balanced multi-asset class unit trust will

charge total investment manager fees amounting to 1.5%

per annum, but these could be as high as 3%.

These levies and fees, when added together, become what

is called the total expense ratio (TER), which is expressed as

a percentage of the value of the investor’s portfolio of assets

being managed. The Association for Savings and Investment

South Africa (Asisa) has introduced a new standardised cost benchmark.

The effective annual cost (EAC) benchmark enables investors to

compare the cost of any investment product with that of another, using

the same benchmark or standard.

The EAC will replace TER and, while not legally required, its aim is

to enable consumers and advisers to compare the costs of different

products instantly, whether it be a unit trust, a living annuity, a retirement

annuity, endowment policy or other investment product.

“Cheaper is not always better, but investors who are aware of the

effect of investment costs on performance and the ability to make

informed comparisons are in a good position to discern which option

will best meet their investment objectives. When it comes to investing,

you don’t always get what you pay for. So it is very important to

invest with providers who not only charge a reasonable amount for

their services, but are also upfront and transparent about their fee

structures,” says Gregory. ■

The compounding effect can do wonders for investment returns. But, equally, the cumulative effect of investment

costs can be damaging over the long run.

Terence Gregory

CEO of Ecsponent

R6. 3

million R 3. 8

million

Cost at 1% Cost at 3%

8 7 6 5 4 3 2 1 0

R m INVESTMENT RETURNS AFTER 30 YEARS,

WITH AN INITIAL INVESTMENT OF R500 000.