The low down on managed fund fees and costs (Part 1): base fees
- Base fees are charged regardless of how a fund performs and vary depending on the asset class
- Small cap and emerging market managers typically have higher base fees
- Watch out for underlying fund fees in diversified funds – it's the total cost to you that matters
When it comes to investment management and superannuation, costs typically dominate the headlines. However, ‘investment costs’ have a number of components and understanding their nuances is critical if you want to compare apples with apples.
Investment costs consist of three main components – base fees, performance fees and transaction costs. In this three part series of articles we look at each component, and today we’ll focus on base fees and how they can vary across the different asset classes and strategies.
What is a base fee?
A base fee (or management fee – the terms are used interchangeably) is paid to the fund manager to cover the costs of running their business (for example, staff costs, rent and travel) and profit margin. In most cases, it should also cover the cost of operating the fund (for example, legal fees, audit fees, custodian fees). Sometimes the management fees and fund expenses (or ‘recoverable expenses’) are set out separately in the offering document. This is purely a matter of presentation and they should be re-combined for the purposes of comparison.
The base fee is charged regardless of how the fund performs. While in one sense you want it to be as low as possible, it’s in your interests that the manager be able to cover their costs – especially salaries for good staff – and remain solvent. You should expect the base fee to vary depending on the asset class.
State Street’s passively managed exchange traded funds (ETFsThe acronym for Exchange Traded Funds. ETFs are funds (unit trust) listed on a stock exchange. Many ETFs are passive index funds, which simply aim to track the performance of major indices (in the asset class being invested in).) highlight how fees more or less increase in line with the complexity of the underlying investments (refer Chart 1). This is driven by numerous factors including the number of holdings within the fund, the number of underlying jurisdictions invested in, the liquidityAn asset is ‘liquid’ when it can be easily converted to cash. Bank deposits, short term bonds and large listed shares are very liquid. Investments such as property and art aren’t. An investor is also said to be ‘liquid’ when they have plenty of cash and other liquid assets in their portfolio or spare borrowing capacity which allows them to make investments at short notice. Liquidity is a reference to how liquid an asset (or investor) is. of the underlying investments and the asset class invested in (funds investing in defensive assets are generally cheaper than those investing in growth assets).
Fees on actively managed funds are higher across the board. This is due to the costs associated with investment research and, in some cases, what the manager thinks they can get away with charging based on past success or effective distribution networks. For example, if the fund uses short selling as a strategy you would expect it to be more expensive than a long only fund. Similarly, international (global) funds tend to be more expensive than Australian share funds and small cap funds more expensive than large cap funds.
Let’s look at some well-known international equities strategies that only charge a base fee and compare them. We’ve excluded those that charge a performance fee as this often reduces the base fee amount.
Table 1 highlights that there is an additional cost from currency hedging (note the 0.06 per cent difference between the cost of the SPDR S&P World ex Australia hedged and unhedged funds). This is fairly typical and is something to keep in mind when considering hedged and unhedged funds. Currency hedging (back to the home currency of the fund) eliminates currency risk as a worry, but it comes at a cost.
You can see also that a fund like Platinum International Fund, which undertakes a lot of different strategies, has a higher base fee than a more vanilla option like the Grant Samuel Epoch Fund. That’s because Platinum not only manages an international share portfolio, it also actively manages its currency exposure (against AUD) and undertakes some short selling (which can be used to reduce its overall market exposure).
The other factor that can impact on costs (as mentioned above) is the liquidityAn asset is ‘liquid’ when it can be easily converted to cash. Bank deposits, short term bonds and large listed shares are very liquid. Investments such as property and art aren’t. An investor is also said to be ‘liquid’ when they have plenty of cash and other liquid assets in their portfolio or spare borrowing capacity which allows them to make investments at short notice. Liquidity is a reference to how liquid an asset (or investor) is. of the underlying investments. All the funds in Table 1 invest in reasonably liquid, listed shares. However a direct property syndicate, for instance, might charge a higher base fee because of the labour intensive nature of managing the investment.
The amount of money able to be invested in an asset class is another significant factor. Small cap managers face all manner of size constraints. For example, consider a manager that wants to be able to invest two per cent of their fund in a sub $200 million market capShort for 'market capitalisation', market cap is the total value of a company's shares. It's calculated by multiplying the number of outstanding shares by the current share price. company. Assuming they don’t want to hold more than five per cent of the company their maximum investment is $10 million. If they want to invest two per cent of their fund in the stock, it means they can’t have a fund bigger than $500 million.
Compare this to a manager focussed on the largest companies only, with multi-billion dollar market caps. They are able to manage a much larger fund, and therefore are likely to have lower percentage fees since the overall dollar fee can be much higher.
There are only around 200 companies in the ASX 200 (surprisingly it isn’t always exactly 200, often due to mergers) but there are over two thousand shares listed on the ASX. For a small cap manager there is generally a lot more choice, and a lot less readily available information on the companies they invest in. This tends to require more groundwork by the managers’ staff, which also tends to increase the cost of these funds over larger funds.
Emerging markets typically have very high base fees as well. As with small companies there is a diverse and fragmented opportunity set and the markets are also geographically vast as well as complex (politically and culturally). Covering this takes substantial time and resources and you would expect your emerging markets manager to have a global team, either with staff located around the emerging markets, or prepared for frequent travel, both of which can be expensive.
While the above explains some of the drivers of higher fees, the biggest single driver is often the fund managers’ past successes. Most funds (not-for-profit funds are the exception) are run by businesses with shareholders who want to earn a return, and if a fund manager can justify a higher fee based on their track record they often will. The key for investors is working out whether or not the fees are justified by the expected returns.
Diversified fund base fees
So far we’ve considered single asset class funds. But what happens to base fees when they are combined into a diversified fund?
As you saw in Chart 1, base fees typically increase with the complexity of the investments. For diversified funds, the same logic applies and a conservative fund will often be cheaper than a growth fund as it holds more cash and fixed interest and less equities.
Also, in this structure, it is possible to have two layers of base fees if the fund invests into other funds. For example, the AMP Future Directions Balanced Fund invests with Ardea Investment Management for their Australian fixed interest exposure. This means investors in the AMP fund are paying fees to both Ardea and AMP, causing their base costs to be higher than if they invested with Ardea and the other underlying managers directly (although we note that this is not always possible).
Let’s use an imaginary example to highlight the maths (shown in Table 2). Pretend a fund manager called X Co decides to launch a diversified fund. It is simply 50 per cent international equities and 50 per cent fixed interest with investments in the Platinum International Fund and Schroder Fixed Income Fund (wholesale class).
The underlying costs would be 1.02 per cent before X Co adds any fees of their own. X Co’s additional fee for the ‘management’ of the diversified fund would need to cover the costs of running the fund, manager research and X Co’s profit margin. If this additional fee was say 0.3 per cent, the total management fee would be 1.32 per cent (1.02 plus 0.3 per cent). X Co might be able to negotiate lower fees with Platinum and Schroders but this still may not be enough to offset X Co’s fees.
We think the guidance is pretty clear from the regulator, but you should watch out for funds which try to avoid disclosing underlying fund fees. It always pays to read the fine print. We have seen managers in the past who have argued that as they couldn’t calculate the fees on the underlying funds with certainty, they excluded them from their calculation of their diversified funds’ fees.
As with single asset classes, the management fees of diversified funds vary widely, and passive management is considerably cheaper than active management. Consider the examples in Table 3. Cheaper is not always better, but remember that base fees are certain to reduce your investment return regardless of how the fund performs. An expensive base fee can add up over time.
The impact of base fees on your return
Let’s look at two hypothetical funds to fully understand what a difference a high base fee can make to your return over 30 years (see Table 4). In this example it changes the final outcome by over 87 per cent of your initial investment amount!
We don’t advocate becoming obsessed with fees, as this is likely to lead to missing out on some funds with stellar performance, but we do think investors need to be aware of what they are paying, and to be comfortable that they are getting value for money.You may form the view (and we often do) that a higher base fee is worthwhile due to the higher returns you expect from a particular fund over time, however in a world of unknown future returns, base fees are a certain deduction from your investment return and can make a material difference to the ultimate outcome. It definitely pays to be aware of them.
Keep an eye out for Part 2 of 'The low down on managed fund fees and costs' where we will look at performance fees in detail.
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