Why You Should Demand Lower Fees - Spear's Magazine

Why You Should Demand Lower Fees

Fee Fi Fo Fum
 
 
William Drake of Lord North Street says that for future profits, demand lower fees now
 
 
COMPOUND INTEREST IS
the Eighth Wonder of the World. One can see one manifestation of this by analysing the effect of fees for active investment management over the medium to long term. We looked at the effect on a £10 million portfolio of paying institutional investment management fee rates rather than normal retail fee rates.

To illustrate this simply, we took a traditional asset allocation of 60 per cent UK equities and 40 per cent fixed income and examined the actual performance of these markets over the last five, ten and twenty years, together with the impact of management fees on the overall accumulated value of the portfolio. Of course income is an important part of the total return on an investment, so we assumed in our calculations that the client was in a position to reinvest income.

As time goes by, not only does the total amount paid in fees rise increasingly for the investor, but the effect is compounded by the absolute performance of the portfolio over the period. The first chart (below) shows the increasingly beneficial impact on value of the lower fees over the twenty-year period, culminating in a £4.7 million increment in value of a £10 million portfolio being charged institutional fee rates compared with one paying retail fee rates.

This was based upon the assumption that the change in value of the underlying investments in the portfolio mirrored the performance of two well-known indices. This gain is equivalent to 47 per cent of the original value! This is achieved by paying institutional fees 0.53 per cent per annum less than retail fees on the portfolio as a whole — our experience at Lord North Street. Over each time period the effect of fees on performance is significant, but the impact of compounding produces striking results over a twenty-year period. This ought to provide food for thought for investors with a longer time horizon. These results would have been even more striking if we had added in front-end fees for retail investors.

We then ran our calculations on the basis that the equity managers added 1 per cent per annum outperformance of the index, net of institutional fees allowing for the fixed income managers merely to match their benchmark net of fees. This does not seem too optimistic.
   
  
 
WE COMPARED THIS model with one using tracker funds charging appropriate fees. The outcome showed two £10 million portfolios, with annual rebalancing, increasing in value to £58.3 million and £49.0 million respectively over the course of twenty years — a difference of 93 per cent of the original value, of which £5.9 million is attributable to the savings in fees gained from paying institutional fees instead of retail.

For the sake of simplicity we haven’t attempted to carry this methodology over to hedge funds and other alternative asset classes, but the conclusions must be the same for all investing: the performance net of fees matters a great deal. Even quite modest stock-picking skills (ie just being able to match the index net of fees) adds very substantially to a long-term portfolio compared with using equivalent trackers (£3.2 million over twenty years), so it’s worth making a real effort to find managers who can outperform to a level that covers their fees (not much to ask but seldom achieved). Just as important is negotiating down the fees paid to the managers, as the difference in the institutional and retail portfolios’ performances demonstrates.

The cynic might say: ‘But no fund managers outperform consistently, so this is all a bit theoretical.’ But we’ve found that by blending a number of managers with different styles and being prepared to shift the nature of this blend to suit market conditions we’ve been able to achieve outperformance in equities, averaging more than 1 per cent per year in equities. In fixed income, performance is more variable but managers have been able to match the index net of fees. 
 
 
William Drake is co-founder of Lord North Street, a private investment office



 

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