Shaking Up Fund Fees

April 23, 2013

Edhec’s index move allows investors to sidestep the fund management industry’s asset-based fees.

 

[This article previously appeared on our sister site, IndexUniverse.eu.]

 

The implications of Edhec-Risk’s decision to offer free constituent information for thirty “smart beta” strategies reach far beyond the index business.

Edhec’s transparency push is clearly a challenge for index firms who seek to charge for smart beta investment strategies on the basis of a percentage share of assets under management. Edhec says it will hand index constituent data out for nothing, only charging for the information if you wish to use its name in a fund you wish to promote.

But the initiative is arguably a bigger threat to the asset-based fees charged by fund management firms of all types.

At the bottom of the fee scale an index fund or ETF will promise index-tracking performance for a relatively small cost, typically levied as a percentage share of assets under management.

For higher fees you can purchase the services of an active fund manager, even though you often end up with something near the index return. That’s because many active managers are criticised for “closet indexing”—keeping allocations close to those of market benchmarks.

Arguably smart beta portfolios also compete directly with hedge funds, to which they offer a dramatically cheaper alternative. This is because smart beta distils the ideas of many quantitative equity strategies, which have historically been offered at hedge fund-type fee scales (a hefty flat fee with a performance “kicker” on top).

It’s not hard to see how, armed with constituent information for a range of index strategies, an investor (or group of investors) could avoid going down the traditional fund route altogether. And that’s surely a long-overdue challenge to the fund business.

One of the key themes in John Kay’s 2012 report on UK equity markets and long-term savings was the inexorable rise of intermediaries and the pernicious effect this trend has had.

Fifty years ago, writes Kay, over half the UK’s shares were held directly by individuals. Now that figure is down to 11 percent, and there’s been an explosion in the number of middlemen standing between savers and the companies they “own”.

“There are registrars, custodians, nominees, fund managers, fund of fund managers, trustees, investment consultants, platforms, independent financial advisers—and more,” says Kay.

“Some of this proliferation represents efficient specialisation—but most results from people looking over each other’s shoulders.”

“The proliferation of intermediaries and intermediation adds to the costs of the equity investment chain,” Kay points out.

“It also creates misalignment of interests as each of these intermediaries pursues the goals of its own business. In the last 12 years, the outcome is that many individual companies have done well enough, financial intermediaries have done very well indeed, and savers have done badly.”

As John Bogle, Vanguard’s founder, puts it on the interview currently running on our sister site, IndexUniverse.com, “no man can serve two masters”. Profit-maximising fund management firms need to satisfy their own shareholders, while also promising to serve the interests of the investors in the funds they run—a fundamental conflict.

 

 

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