Being Realistic About Fees

In the article, Being realistic about prospective returns, we covered the issue of historical returns and how investors have been rewarded. As mentioned in that piece, the figures used assumed the investor had the knowledge and discipline to manage the portfolio themselves.

More commonly, investors do value their time and not many have the requisite skills to manage a portfolio. That means they need to hire someone to do that job. In the article Evaluating an investment advisory service we cover the broad issues of what makes for an adequate professional service. Here we focus purely on the fees issue.

Knowing what you’re paying

You get nothing for free, so the issue comes down to what is a fair, value for money service. There is a wide range of advisor fee arrangements and arguably in New Zealand the most ubiquitous are fees which the investor isn’t aware of. These are the trail commissions very common in the unit trust sector.

The most important fee issue for an investor to come to grips with is getting full and frank disclosure from the advisor on all fees they receive. It is vital the advisor is incentivised only to promote the performance (maximum return and minimise risk or volatility) of the investor client. So receiving fees from promoters of funds, trail commissions, brokerage and any sources that are not directly from and known to the client is a no no.

An example illustrates. As the pressure has come on the NZ broking industry we now have the spectre of double dipping in that sector as they move to advisory fees but also retain broking as an income source. So the broker is incentivised to encourage the investor to trade their portfolio so that brokerage can be earned but also earns an advisory fee for that advice. The broker is no less conflicted than a advisor/salesman selling a unit trust product who receives both a trail commission from the issuer of the units as well as an advisory fee from the investor. In that instance the advisor is compromised by steering his clients into products where he gets a sales commission.

Why has this situation arisen?

The main reason is because the promotion to investors that they shouldn't pay fees. This forces the investment industry underground getting the income necessary to provide the service they do, from sources not apparent to the investor. Brokers declare they don’t charge fees – they do, they’re in the brokerage, the underwriting fees common with new issues, and the fees paid by companies to have their scrip promoted. Financial planners get their fees commonly from payments by the issuers of unit trust and other investment products.

So investors pay fees – one way or another. That they don’t always know how much is a common characteristic of the industry in New Zealand. Finding out is a major obstacle investors face and too often their returns are demolished by the undisclosed fees in their investment activities.

What can you expect to pay?

The designs of advisor fee arrangements are wide and varied and are covered in the piece, Evaluating an investment advisory service. Here we consider the level and impact of a reasonable fee for service.

A flat fee arrangement (not uncommon) where fees equal a proportion of the funds under management would have impacted historical (1926-2000, US) returns as follows:

	Raw real returns	DIY real returns after tax	Managed real returns after tax
Stocks	8%	6.6%	5.7% - fees at 1%pa
Bonds	3%	1.0%	0.8% - fees at 0.3%pa
Cash	0.8%	-0.5%	-0.5% - fees at zero pa

The table indicates that after inflation the market average annual return for stocks has been 8% pa over the 75 years. But this ignores the fact that dividends are taxed. Taking account of this and assuming one was skilled enough to procure market average returns (70% of investors haven’t !!) and assuming your time is worth nothing then the Do It Yourself (DIY) return on stocks has averaged 6.6% pa. Either costing your time or hiring a professional that achieved market average returns (no mean feat even for them!) reduced that return to 5.7% pa.

Similarly the whole return from bonds and cash is taxable so respectively they have returned 1% pa and –0.5% pa over the 75 years.

What is the cost of investing?

Costing the time of the investment manager realistically then – and 1% pa for stock portfolios is certainly exceeded by many stock managers – suggests costs of having a portfolio managed as follows:

stock	70%	60%	50%
bond	20%	25%	30%
cash	10%	15%	20%
portfolio size
200,000	1,434	1,260	1,086
300,000	2,152	1,890	1,629
400,000	2,869	2,520	2,172
500,000	3,586	3,150	2,715
1,000,000	7,172	6,301	5,429

The "reasonable" cost of managing a $500,000 portfolio is going to be between say $2,500(50% stocks) and $5,000 (100% stocks) – excluding brokerage. Now of course there’ll be cheaper (you get what you pay for) and dearer. This piece simply endeavors to give you an idea of the reasonable range.

It’s most important for investors though to be confident that they can "see" all the fees they are paying. Unfortunately in New Zealand such transparency is not at all common. Brokers rightly slag the hidden trail commissions that financial planners reap from unit trusts, while themselves being conflicted often through fees reaped from promotion of dubious new floats to their clients. Most of these in the last 10 years have provided less-than-market returns, making the broking industry less-than-transparent advisors as well.

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