Research by Chant West Financial Services claims that making fee comparisons across super funds is “highly misleading”, because many fund-of-funds in the alternatives asset sector are understating their real fees. STEPHEN SHORE reports.

A number of fund managers have been increasing their exposure to alternatives recently. Mercer Investment Consulting ran 20 per cent more searches for alternative asset managers in 2007 than it did in 2006, and according to Chant West, industry superannuation funds have, on average, doubled their allocation to alternative assets (from 7 per cent to 14 per cent) over the past two years. But comparing these investments has become difficult for investors because many of these alternatives (such as private equity, infrastructure and hedge funds) are accessed through fund-of-fund vehicles, where there is almost universal non-disclosure of underlying manager fees – both base fees and performance fees, the report says.

For example, the most common objective in a hedge fund-of-funds product is to earn the cash rate plus 5 per cent per annum, net of all fees (about 12 per cent in today’s market), the report says. “What is little understood [by fund investors] is that, in order to do this, the product has to earn about 20 per cent per annum gross.”

This is because the total fees can amount to about 8 per cent, leaving the investor with about 12 per cent. Typically, only the lead manager’s base fees and performance fees are disclosed – around 2 per cent – leaving the underlying manager’s base fees, administration costs and performance fees – around 6 per cent – undisclosed. In this example, if fund-of-funds alternatives represent 5 per cent of a super fund’s total assets, then the overall management cost will be understated by 30 basis points, the report says.

“This is a material figure given many funds report management costs in the range of 60 to 80 basis points. And if fund-of-fund alternatives represent 10 per cent of total assets, overall management costs will be understated by 60 basis points (and at 20 per cent it is 120 basis points).

“Non-disclosure of fees in the alternative asset sector is a chronic problem facing the industry, and one that needs to be addressed urgently,” the report says. “It severely hinders fee comparisons across funds, and leads investors to be inadequately informed about the costs they may incur.”

Ian Fryer, research manager at Chant West, says that while the report is primarily referring to fund members being unaware of the true cost of their fund’s investments, even some funds managers are not fully aware of the underlying fees in this asset class. “We had some contact with one major superannuation fund, where it hadn’t been clearly communicated from the asset consultant what the fund was actually paying. A 12 per cent return net of fees may sound reasonable if you think the fees are only 2 per cent. But if 12 per cent net-of-fees return means 20 per cent gross, you may begin to question whether that is achievable – especially as more people enter the alternatives space and it becomes harder to get those returns.”

Fryer says the lack of disclosure has arisen from debate around the interpretation of the Explanatory Statement to the Corporations Act Amendment Regulations 2005. “From some funds’ point of view, fees taken out of excess returns are not important, as long as the net return is achieved,” he says. “But we think it is pretty clear that the statement says funds need to declare all fees, gross of tax. Even leaving that aside, the true level of fees is something members would expect to be told, especially now that the spotlight is turning back to fees… Most funds realise these fees exist, but they are reluctant to disclose them because no-one else is doing it. They are just going to look at each other waiting for someone else to move first… Whoever declares all of the underlying fees first is going to look really expensive compared to the other funds. This needs leadership or regulation from a body such as the ASIC.”

Even discounting the non-disclosed underlying manager fees, the lead manager fees for most alternatives are more expensive than traditional asset classes. While retail master trusts have been improving their efficiency over the past few years, these reductions in fee margins have been largely offset by increased investment fees, due to greater allocations to alternative assets, the report says.

Industry fund fees have increased by 12 basis points over the past three years (partly because of the growing cost of compliance, promotional budgets, and improved fee disclosure), due to higher investment fees from increased allocations to alternative assets and the impact of performance fees.

Some funds have offset the higher investment fees of alternatives mangers by cutting costs in other areas of the portfolio, such as enhanced-indexing their equities exposure. According to the report, the main factors affecting fees charged by an industry fund are the allocation to alternatives, performance fees, and size of fund.

Among the industry funds over $7 billion, the report found UniSuper had the lowest fees. But UniSuper has only 7.5 per cent in alternative assets whereas HESTA and Cbus (the two most expensive industry funds) have 18 per cent and 19 per cent in alternatives respectively. HESTA also includes performance fees of 25 basis points, whereas UniSuper does not disclose any performance element in its investment fee.

These higher fees may be justified, however, by better performance. Chant West’s latest quarterly returns survey found Cbus and HESTA were top and bottom of the first quartile respectively. UniSuper, while still performing well, fell in the mid to lower second quartile.

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