Charges are not always transparent so it is up to the investor to negotiate discretionary investment management fees; but remember: the cheapest deal does not necessarily offer the best value
The best way to illustrate how most investment management fees work is by example. For instance, say there is £5m invested and it grows at a compounded rate of 8% per annum (pa), then after 15 years the fund will be worth £15.8m.
Now consider how the fund would be diminished by the impact of investment management fees. If charged at 1% pa, the fund will be worth only £13.7m - over 13% less. While 1% pa may not sound a great deal, compounded over a long period the impact is material.
This example illustrates why fiduciaries must ensure investment management fees are reasonable and fair. But what is fair? Although most investment managers have set fees, in reality, the world of private client investing is so competitive most charges are negotiable.
To begin with, size matters. The bigger the investment the more opportunity there is to shape the sort of agreement the client wants. Accordingly, for smaller portfolios there may be merit in bulking funds to create a critical mass and then working with a handful of investment managers on preferentially negotiated terms.
Now suppose that 1% pa fee has been successfully negotiated down to 0.75%. Job done? Unfortunately not, because the devil is in the detail not the headline rate. What now needs to be considered is the impact of dealing charges, upfront fees and exit penalties.
A further complication is where the investment manager proposes to deliver all or part of the investment solution using its own in-house funds. Typically these funds charge an extra 1.5% pa - good business if you are the investment manager, not so good if you are the client. Little wonder then that this practice is commonplace. Even supposing the in-house funds in question are chosen on merit, at the very least investor's need to make sure the management agreement explicitly states they will not be double charged.
And then there is custody (the cost of housing the investments). There are custodians offering a choice of rates ranging from 0.1% pa to 0.4% pa. Why is there such a difference? Like most things in life if it sounds too good to be true, it probably is. Choose the apparently lowest cost custodian and, through hidden costs, investors will almost certainly end up paying more than the superficially attractive headline rate (particularly if there are plenty of foreign exchange deals going on). Again the message is check the agreement or better still negotiate a single, all-in price that includes custody and all other charges.
paid to perform
Increasingly, performance fees are becoming common. The idea here is the fee should be proportionally related to performance. For example, the better the performance the more the manager gets paid. For many clients this arrangement holds an intuitive appeal - most likely because in their minds it provides the investment manager with an extra incentive.
Personally, I am not a great fan of performance fees. For a start why should any investment manager require an extra incentive to perform? If there is doubt that the investment manager is sufficiently motivated, a better solution is to invest in funds where the manager holds a meaningful amount of their personal wealth.
Another problem with performance fees stems from the fact that in the world of investments it is risk that drives returns. So if returns are poor (therefore no performance fee), the manager may be tempted to increase risk to a level that becomes unacceptable. Put crudely, it becomes a game of double or quits. Where funds are involved, clients may come across the two and 20 rule, which means 2% pa and 20% of the profits in fees. Apply this formula to the original example and the final value of the fund is only £10m, with fees having swallowed one-third of all gains.
The message is clear - caveat emptor - let the buyer beware. In particular, make sure the agreement includes the existence of a high watermark and a worked example showing how portfolio performance will be calculated in the event that funds are added or removed from the portfolio. Of course if, after all costs, a manager performs in line with client expectations it should not matter what is paid in fees. There are a number of very talented managers with long and consistent track records of skill-based investing who can, and do, justify fees of two and 20 and sometimes more. However, most investment managers do not, so either negotiate or look elsewhere.
Attention to detail
Once the portfolio is up and running the trustees will receive periodic valuations and trading statements containing information that will need to be transferred into trust company's own systems and ledgers. If this is a manual process it may become both time consuming for the trustees and costly for the underlying client. On the other hand, if the investment manager is able to provide data updates directly into the trustees' system the cost savings can be taken into consideration when negotiating fees.
Many clients have complex tax arrangements that specifically proscribe certain investments, require the strict separation of capital and income, and the production of documents for submission to tax authorities. For trustees attention to detail is paramount, specifying the frequency, accuracy and content of reporting should be a key component of the investment management agreement.
Occasionally face-to-face performance reviews will be required where the underlying client, trustees and investment managers all come together. Considerable travel costs may be incurred, so if these meetings are going to be a regular feature of the relationship it needs to be understood from the outset who is expected to pay.
Because many of the costs of managing an investment portfolio are fixed for smaller portfolios, the most cost-effective solution is almost certainly to access investment markets via funds. However, using this route there will be less scope to tailor the investment management agreement because the products tend to come in a standardised one size fits all package. If lower fees can be negotiated, the mechanics of running the fund dictate the benefit will be passed to the client in the form of extra units rather than a reduced annual charge.
A final thought, apply some common sense, all that glitters is not gold and the cheapest deal is often not the best value. Remember, above all a good deal is one that works for both sides.
While a 1% per annum fee may not sound a great deal, compounded over a long period the impact is material
While all fees are negotiable, investors should not just look at the the headline rate, but also consider the impact of dealing charges, upfront fees and exit penalties
Be wary of performance fees. Look instead at funds in which the manager has their own money invested
Look out for the two and 20 (2% pa and 20% of profits) performance fee rule. Most managers do not justify such fees so negotiate or look elsewhere
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