In a short newsletter entitled ‘Now You Fee It, Now You Don’t’, Brett Elvish, from consultancy Financial Viewpoint, looks inside the realm of undisclosed costs within the superannuation and funds management industry. He finds that in some cases, published fees within the investment industry – for functions ranging from master custody to fund of hedge funds (hedge FoF) investments – are just the tip of the true costs iceberg. The Treasury’s Enhanced Fee Disclosure Regulations of 2005 are not helping the situation, Elvish says. “Not so long ago funds would appoint a small number of equity, fixed interest and property managers. Investments would be primarily via simple instruments (e.g. shares, fixed coupon bonds), and a custodian would help with the record keeping. The Enhanced Fee Disclosure regulations were designed with this relatively simple world in mind,” the consultant points out.
“Today, funds are investing with a large number of managers, managing investments directly, engaging investment banks, using a diverse range of investment instruments and structures, with a custodian providing a broad array of services. The regulations are now out of step with the “normal” investment arrangements of most funds.” The investment industry is largely content to let the bulk of these undisclosed costs remain in the dark, since they are not required to report them under the current fee disclosure rules. However, some companies are more forthcoming than others and acknowledge some of these costs in their published fees. Competitors who aren’t so open have the opportunity to gain a marketing edge because their fees seem lower. “There is a myriad of different ways in which people manage their costs, resulting in published costs being misleading,” Elvish says. “There are an enormous range of costs that don’t get disclosed, like brokerage. They don’t get reported in the cost structure and don’t get disclosed to the [super fund] member.”
There are at least 33 strategies funds can use to visibly lower their fees to enhance their competitiveness while still being exposed to the same underlying costs, he says. This has been made possible because the innovation and complexity of the funds management industry has outpaced the legislation governing disclosure. Super funds’ ability to hide the real costs of their operations undercuts the federal Government’s aim to lower average member fees to 1 per cent: even if published fees are driven down to this level, other costs will still loom outside the figure in the product disclosure statement. “You can make announcements about 1 per cent fees, but if the 1 per cent is really 1.5 per cent or 2 per cent, it becomes a bit meaningless,” Elvish says. Elvish points to a typical master custody arrangement to reveal an instance where true costs and published fees are not aligned. The custodian earns revenue by providing services – safekeeping, settlement and reporting – in addition to capturing spreads on interest rates while managing cash and conducting foreign exchange transactions, and they can also take a share of the revenue earned from securities lending operations. But judging by the published fees they receive, master custodians make money solely by providing services.
These fees don’t account for the income earned from securities lending, cash and forex management, thereby misrepresenting the true cost of super funds’ business with master custodians. This provides funds with an opportunity to publish low expenses for custodial services despite larger true costs. Another accrual of indirect costs occurs when funds invest in index products with a zero management expense ratio. The super fund pays no management fee, but any outperformance eked from the replication process – “the cream off the top of the product” – is pocketed by the manager, Elvish says. “In this situation, the manager gets the fee from the process, but in a published sense they provide a zero-fee product.”
These indirect fees are earned in all aspects of a superannuation fund’s operations, including product design, asset allocation, investment strategy, investment management, transition management, broker relationships and custodian arrangements, Elvish says. The exclusion of indirect costs from fee statements is legally permitted because the enhanced fee disclosure regulations were written at a time when super funds ran simpler portfolios consisting of equity, fixed income and property managers. Funds now implement far more complex investment strategies.
They allocate to an array of managers across different asset classes, own assets directly, use various investment interests while custodians perform a range of functions beyond record keeping. Fee disclosure rules are now out of step with reality. As a result, it is possible to “knowingly or inadvertently disclose vastly different fees for products which have very similar true costs,” Elvish says. The legislation aims to expose the additional costs taken on by super fund members, such as custody and brokerage, which they would not incur to if they invested their savings directly. In an industry built to support the financial wellbeing of millions of people in their retirement, and one that enjoys a guaranteed customer base, low-cost products should be the norm.
To achieve this, an accurate comparison of the true costs is required. But the existing Treasury regulations clearly don’t enforce this: they need to be improved to make it compulsory for funds to state these costs. Elvish says a good starting point would be for industry businesses to “pay their own way” and start disclosing indirect costs. “But it’s just like tax legislation. They change something and smart people manoeuvre around it. This is the same situation,” he says. Because indirect costs are never fixed – can a custodian predict how much money they’ll net from foreign exchange rate spreads during a three-year contract? – precise comparisons of the true operating costs of super funds are almost impossible to make.
But reliable estimates could be calculated more easily to help funds overcome this problem. The biggest obstacle in the way of true cost comparisons, rather, is acceptance that fees reported to members would inevitably be higher. “If you think about it from a commercial perspective there are significant financial incentives to have a lower fee outcome to be more competitive and more profitable,” Elvish says. Industry funds, in particular, would loathe the loss of their apparent low-cost advantage over retail super providers. “There’s no incentive. That’s the problem,” Elvish says. The incentives are probably skewed in the other direction. Government pressure has been obviously to reduce costs, and to appear to be as cheap as possible is important.” Ratings houses also respond positively to low fees. But Elvish warns that too much pressure on trustees to cut fees might force them to prioritise price instead of performance.
“You want your trustees to make the best investment decision to achieve the best risk/return outcome for your portfolio on a net-of-fees basis,” he says. You don’t want them to be obsessed with the fee outcome, but the return outcome.” Trustees should also investigate the true costs of the operations of service providers, such as funds managers, knowing that the published fees they offer might omit indirect costs. For example, some fund managers use soft dollar gifts to help smooth relationships with brokers, while swap structures in some hedge fund-of-fund allocations ignore underlying manager costs. Given the ability of managers to cut fees while being exposed to similar true costs, trustees could potentially forgo investing in a range of attractive strategies that appear expensive, opting instead for lower-cost products. But both products actually carry similar true costs. The fund might miss out on investment skill while making no real fee savings. “You want obsession about the right things, not the wrong things,” Elvish concludes.