Cut down to size

The European Union – or what’s left of it – wants the total cost of investing, not just the nominal management fee, to be spelled out in black and white on all fund prospectuses from now on. This looks like bad news for certain giant funds, which, despite their economies of scale, squeeze end investors with some of the highest overall costs in Europe. As the true price of investing in funds becomes increasingly clear to the man in the street, it may well be time for funds to cut the costs they pass on to investors.

Investment funds sold in Europe can hide their total expense ratios (TERs) no longer. The European Commission has said that TERs should appear in all fund prospectuses as part of its recommendations on simplifying literature for investors (see the EC Recommendation of 27 April, 2004, on some contents of the simplified prospectus, as provided for in Schedule C of Annex 1 to Council Directive 85/611/EEC (2004/384/EC).)

Cost pressures

European governments are beginning to act on this recommendation. In Spring, for example, the UK’s Financial Services Authority issued new rules requiring TERs to be shown on shiny, new and clarified documentation for investors. The management fee and any upfront, one-off fee associated with a fund have long been out there for all investors to see. The TER, however, has been a more elusive beast.

Ed Moisson, associate director at Fitzrovia, the subsidiary of Lipper that tracks TERs independently, explains that the TER is the full cost of investing. It includes not only the management and upfront fees but also a range of other costs that are passed on to investors indirectly. These indirect costs include the price of administration and custody for the fund, auditing fees, legal fees, marketing costs and sometimes distribution fees. They are charged to the fund and the fund meets them by slicing off money from its returns. In this way, the investor pays additional costs.

It seems right that these costs should be made be clear to the end investor. But with TERs suddenly in the spotlight, how will investors react? “Hopefully, as the retail market becomes more aware of TERs, over the long term it will put pressure on companies to decrease these costs,” says Mr Moisson. The implication is that TERs are unfairly high – and the most obvious way to reduce them would be to cut management fees.

Tools and resources

A glance at Fitzrovia’s research certainly suggests TERs are unfairly inflated. Take one of Europe’s favourite funds, Fidelity’s European Growth product. According to Fitzrovia, it is the biggest active European equity fund domiciled in Luxembourg, with a massive $21bn (E17bn) in assets. It would be natural to assume an economy of scale would be at work here, resulting in a low TER – yet this fund has the highest TER of the top ten biggest funds in its class, at 1.96 per cent. The second biggest fund, run by Schroders, is little better, with the third heftiest TER of the top ten, at 1.82 per cent.

Michael Jones, head of UK distribution at Fidelity, defends its TER, arguing that good funds have the right to charge more, especially because they are costly to run: “The best funds in the market can command higher fees. Every fund management company does it differently,” he says. “If you are running a passive index fund, that is very different to being a bottom-up stock picker. We add value by doing stock selection better than anyone else. To do so we have to give our fund managers more tools and resources, pay them well and provide them with the infrastructure and systems they need. The cost of running such a business is really quite high.”

In-house analysts

He gives the example of Fidelity considering an investment in the medical sector. “Say we were looking at a company that made hearing aids. We have networks of up to several hundred doctors with whom we would consult on the product. We would ask them what they think of it and whether they would use it themselves; we would take into account industry research; and then we have 55 in-house research analysts covering all sectors in Europe and the UK.”

Gavin Ralston, head of Continental Europe at Schroders, also maintains that higher fees are justified for funds that deliver outstanding performance: “People are willing to pay higher fees for a good product,” he argues. “Institutional investors can benefit from economies of scale, but for retail investors there is a single fee. The only argument for a lower fee would be if the fund is not able to deliver the performance the client is looking for.”

Fidelity’s European product is the top performer of the past 12 months, according to returns independently measured by Standard & Poor’s. It delivered just under 38 per cent for the period. However, Schroders’ equivalent product does not even make S&P’s top 20 best performers. Similarly, Nordea’s European Value fund has the second highest TER, despite having a substantial $2.45bn in assets, and it also fails make the list of top 20 performers.

Moreover, Ed Moisson at Fitzrovia says broadly speaking, “TERs come down as fund size increases” – which suggests that larger funds do benefit from economies of scale. Fitzrovia's research (dated January 2005) shows that funds with assets under $25m have higher average TERs than the largest vehicles, with assets of $250m.

The smaller funds have TERs of 2.01 per cent, while the average TER for the larger group of funds is 1.67 per cent. Yet the picture is not uniform, with funds between $50m and $100m having an average TER just one basis point lower than those funds between $100m and $250m.

So why are some TERs relatively high? “There is always a question of why fees are at a certain level. I suppose it is a question of what the market will bear,” says Mr Moisson.

Fees on rise

For TERs to come down, he says, management fees would have to be trimmed but instead, he believes they are growing. “My impression is that management fees are going up due to the cost of distribution.”

Funds are having to pay larger amounts of money to the banks, insurers and financial advisers that sell them. “Intermediaries are the key to selling a fund and in order to get on their shelves your fees have to be high enough for the distributor to consider your fund,” says Mr Moisson.

Yet there is a check on the management fee, he adds: “At the same time, it is recognised that high fees will hit your track record of performance, so that helps to keep fees under control.”

However, the most effective attack on fund costs would be one that came from the end investors; if they stopped investing with the funds charging high TERs, this would spark competition. As Matteo Bosco, chief executive of Credit Suisse Asset Management Italy, says: “The regulator will not induce us to reduce TERs. The only thing that can do it is competition.”

Credit Suisse runs the fourth biggest European bond fund, which has the ninth biggest TER of the top 20 in its class, at 1.02 per cent, according to Fitzrovia.

But Mr Bosco doubts a lowering of TERs is on horizon. “TERs may be in the fund prospectus, but the prospectus is something that the client never reads. The one person who could influence the investor in this regard would be their investment adviser. They should look at prospectuses. But, of course, they don’t – because higher fund charges mean higher fees for themselves,” he says.

However, Jasper Berens, sales director for UK retail at JP Morgan Asset Management, believes that investors are wising up to TERs. “We know that people have become more aware of the TER. We are looking closely at our TERs as a result.”

Change of heart

JP Morgan runs the third-largest European equity fund, with assets of $4.06bn. Its TER is 1.65 per cent and S&P ranks it 19th in its class over the past 12 months. If JP Morgan decides to cut its TERs, this would spark off the competition that Mr Bosco described, and it seems likely the rest of the major funds would follow.

Even Mr Jones at Fidelity admits: “TERs are important in the market we are in now where we are seeing more normal returns from stocks and bonds.”

Perhaps a slashing of funds costs is closer than some might believe.