“There are risks and costs to action. But they are far less

than the long range risks of comfortable inaction.”

– John.F Kennedy

Introduction

If you were a pro-cyclist trying to win the Argus and you could (legally and honestly) increase your chances of reaching your goal by just shaving off some weight off your bicycle and yourself, would you do that? If you were to climb Mount Everest and could increase your chances of reaching the summit by slightly reducing the weight of your back pack, would you do that? In both of these examples physical weight is putting a drag on your performance and reducing your chances of reaching your goal.

When it comes to saving for retirement, you have a similar situation. Costs associated with your investment are those often ignored factors putting a drag on your performance and reducing your chances of reaching your ultimate financial goals. Being mindful of the small things such as cost-drag can relatively easily improve investors’ performance.

Are all costs created “evil”?

 Are all costs bad? Certainly not.

Financial advisors, administrators or platform service providers and investment managers each fulfil a very important role and need to be remunerated for their work. Fees are multifaceted, can be complex and opaque.

What investors should be mindful of is that they understand what exactly the fees are and that they are comfortable paying the fees for the service rendered. What we are concerned about in this article is that there comes a time when the additional cost outweighs the additional benefit or some fees might be excessive compared to another provider.

Suppose you are faced with a selection between two investment managers with similar track records, investment processes and skill but the one is more expensive than the other? Or what if you have to choose between two platforms to administer your investment and they both have great online functionality, a wide selection of fund choices, provide excellent administrative services and are reliable, aren’t you going to choose the least expensive one?

Explanation of costs

To provide a better understanding of related costs, we are going to focus on costs related to an investment in a collective investment scheme (a unit trust) on a LISP (Linked Investment Services Provider – which is the South African jargon for an investment platform). We are not going to expand on any additional fees associated with wrappers or fund of funds fees.

Normally there are three costs associated with a unit trust investment namely, financial advisory fees, administrator or platform fees and investment manager fees (collectively referred to as “costs” in this article).

FINANCIAL ADVISORY FEES 

The financial advisor will charge his/her client for the services they render which might include, for example, performing, drafting and implementing a financial needs analysis, investment strategy, investment manager selection, portfolio construction and performance monitoring.

These fees can be initial (once-off) fees on a lump sum investment or initial (once-off) fees on every debit order and/ or annual advisory fees which are ongoing.

On average, financial advisors charge an initial once off fee for the initial work to define and investment strategy and financial plan. Such could be costed on an hourly basis and may range between 10 hours and 20 hours depending on the complexity of the client’s requirements and objectives and sophistication of the investments.

Thereafter, the financial advisor will charge an annual fee expressed as a percentage of the assets to which they advise. Such a percentage will be defined based on the size of the assets of the client. The smaller the asset size the higher the percentage and vica verca. On average, financial advisors charge 0.50% to 1.0% as an annual advisory fee.

ADMINISTRATIVE/PLATFORM FEES 

The administrative or platform fees are related to a Linked Investment Service Provider (LISP).

A LISP is a company that enables you to invest in a wide range of collective investment schemes, such as unit trust funds, via one entry point or platform. The LISP will manage the administration of the investment for the client which includes the processing of cash movements in and out of funds, performance calculations, monthly statements, online access to investments, and provision of tax certificates. These fees can be levied by way of initial and/or annual fees and are normally based on a sliding scale.

On average, LISPS also charge an annual administration fee expressed as a percentage of the assets which they administer. Such a percentage will be defined based on the size of the assets of the client. On average, LISPS charge 0.50% as the minimum annual administration fee but then reduces as per asset scales to as low as 0.10%.

INVESTMENT MANAGER OR INVESTMENT PRODUCT FEES 

Investment managers charges an annual fee (as a % of assets) for the day-to-day management of the investment or fund. Usually a fund’s performance is shown net of fees as unit trust prices are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any permissible deductions from the portfolio divided by the number of units in issue.

Investment managers management fees are expressed as a percentage of the assets which they manage. Some investment managers also charge a performance fee in addition to the management fees should they exceed a certain benchmark or minimum return. The investment manager therefore shares in your gains when they outperform an agreed investment target.

There is little proof that incentivising investment managers with an additional performance fee component actually makes a meaningful difference to investors’ returns, though investment managers may see the benefit of such. Quoting a previous Grant Thornton UK study, National Treasury highlighted in its retirement fund charge paper that performance fees didn’t make much of an impact on investment manager performance. Their main effect “appears to have been to increase financial returns to investment managers”.

In reality there are so many pitfalls in the way performance fees are calculated that as a rule of thumb we would recommend investors to rather opt for management fee structures only without any peformance fee component.

On average, we have found that for a balanced multi asset class unit trust, the total investment manager fees amounts to 1.50% per annum but could be as high as 3.0%.

These fees are disclosed on the investment manager’s fund fact sheet. Be mindful not just to take the annual management fee or fee at benchmark into considered because typically, that is not what you are going to pay. The cost that will be deducted from the unit price is the Total Expense Ratio (“TER”). The TER shows the charges, levies and fees relating to the management of the portfolio and is expressed as a percentage of the average net asset value of the portfolio, calculated for the year at the end of the most recent completed quarter. A higher TER does not necessarily imply a poor return nor does a low TER imply a good return.

Impact of costs on your investments

Costs can make a difference over a one year period, however cost-drag which is the magnitude of the difference that costs make on performance over time, is staggering.

Let’s take an example where you appoint a financial advisor and then invest R500 000 in a fund of fund unit trust portfolio i.e. a unit trust porfolio that is diversified accross more than one underlying investment manager and more than one fund and more than one asset class. You have a choice between two fund of fund unit trust portfolios who both produced performance of 10% per year before fees, but the first fund of fund unit trust portfolio charges total fees of 3% per year while the second fund of fund unit trust charges fees of 1% per year.

The table below shows the performance if you invested R500 000 with the first fund of fund unit trust portfolio. In year one you start with a lump sum contribution of R500 000. You received a return of 10% (R50 000), costs were 3% (R15 000) leaving a net performance of R35 000, hence the total portfolio value is R535 000. If the investment and costs remain unchanged over the years, it will give you a total portfolio value of R983 576 after 10 years, R1 934 842 after 20 years and R3 806 128 after 30 years.

YEARSTART VALUEPERFORMANCE (BEFORE COSTS)COSTSPERFORMANCE (AFTER COSTS)END VALUE
1500 00050 00015 00035 000535 000
5655 39865 54019 66245 878701 276
10919 23091 92327 57764 346983 576
201 808 264180 82654 248126 5781 934 842
303 557 129355 713106 714248 9993 806 128

The table below shows the performance if you invested R500 000 with the second fund of fund unit trust portfolio. In year one you start with R500 000. You received performance of 10% (R50 000), costs were 1% (R5 000) leaving net performance of R45 000, hence the total portfolio value is R545 000. The investment and costs remain unchanged over the years, giving a total portfolio value of R1 183 682 after 10 years, R2 802 205 after 20 years and R6 633 839 after 30 years.

YEARSTART VALUEPERFORMANCE (BEFORE COSTS)COSTSPERFORMANCE (AFTER COSTS)END VALUE
1500 00050 0005 00045 000545 000
5705 79170 5797 05863 521769 312
101 085 947108 59510 85991 7351 183 682
202 570 831257 08325 708231 3752 802 205
306 086 091608 60960 861547 7486 633 839

The table below compares the end values for the two fund of fund unit trust portfolios.

YEARFUND OF FUND 1FUND OF FUND 2DIFFERENCE (COST-DRAG)
1535 000545 00010 000
5701 276769 31268 036
10983 5761 183 682200 106
201 934 8422 802 205867 363
303 806 1286 633 8392 827 712

Cost-drag amounted to R867 363 after 20 years and R2 827 712 over 30 years. Clearly costs should be a major factor as part of your investment decision making process.

Conclusion

In the end all the little things add up to make a big difference. It is important to consider all costs when selecting a financial advisor, LISP and investment manager.

Just like shopping or paying for a service, you need to compare the initial fees and annual fees of service providers and be aware of any additional costs as they may influence your investment significantly.


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