The effect of reverse compounding is "pretty toxic" to passive investing returns once the fees of the full value chain of advice are taken into account, BMO GAM multi-manager co-head Rob Burdett has said.
The BMO GAM team subtracted varying charges - ranging from 1% to 2% - to simulate different extents of the full value chain of investing, including adviser fees. It then tracked how these fees compounded and dragged on returns from the MSCI World index, from August 2001 to December 2017.
With no charges, the MSCI World index saw a 205% return in this period. BMO GAM compared this with its global equity boutique product, which saw a 219% return over the same timeframe - after taking into account BMO GAM's fees, underlying fund fees, the adviser and platform fees, for a typical ongoing charges figure of more than 2.5%.
"We are regularly hearing 2% for the round trip for the cost of investing through the adviser channel," said Burdett. "If you take that 2% off the MSCI World - that is a bottom line of 123% compared with 205% for the base index."
As the chart below illustrates, BMO GAM's research also found the MSCI World with 1% fees would have returned 161% over the period, while 1.25% charges would have given investors a 151% return.
Source: BMO Global Asset Management
"This 'reverse compounding' is pretty toxic," Burdett added. "It often gets missed in our part of the investment community. So if you want to pay for advice from your investment you almost have to go active."
Burdett referred to Platforum research, released earlier this week, which found fewer than one in seven advisers (15%) invested more than half of clients' portfolios in passives.
"Thankfully, according to this research, there are not that many [advised passive investors]," he continued. "So certainly on that piece of analysis this is not a huge problem yet. But it is something we lose quite easily in the active/passive debate, if advice needs to be paid for."
MPS ‘safe buys'
Burdett also questioned the growing use of model portfolio services among advisers, particularly in the context of additional requirements under the second instalment of the Markets in Financial Instruments Directive (MiFID II).
"The advent of model portfolios is pumping - the same funds are appearing in every one pretty much," he said. "Big, well-known, long-established funds - 'safe buys' that are open to as much money as they can take - and then that inevitable compromise happens."
He added: "I'm not criticising but there is an extra requirement to the model portfolio that multi-managers just do not have. We have whole-of-market access and no admin reasons why we cannot buy a fund. We can buy funds at different fee levels, at closed capacity, listed vehicles and open-ended."
Burdett also predicted additional reporting requirements, as well as liability for any risk management on investments under MiFID II, would "shake up" the industry and the use of model portfolio services.
"We are comparing these with funds we own, which is again comparing apples and pears," he acknowledged. "But it shows we are free to choose the sweet spot in each team, not the big fund that is open to investors forever, which is a safe buy and everyone recognises it."
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