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The price is right?

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17 April 2019

Simon Elliott, head of investment trust research at Winterflood Securities, has argued that lower fund fees are not always good news for investors, David Prosser evaluates.

Lower fund charges must be good news for investors in funds, right? Not necessarily, argues Simon Elliott, Winterflood Securities’ head of investment trust research in a fascinating article just published in Investment Week. He argues there is a danger that investment company boards’ efforts to drive down fees in recent years could backfire because if fees go too low, competition between fund managers to manage investment companies may suffer. Some managers – possibly the best ones – may decide they no longer want to be in this business, Elliott warns.

It’s a new take on an old argument. What advisers and investors really want from any investment fund is superior performance – and most don’t mind paying for that. If you knew that of two funds with different charges, the more expensive one would definitely deliver better returns, you’d be sure to choose it over the cheaper alternative.

Trouble is, of course, that advisers and investors don’t have access to future performance records at the time they make their purchase, whereas charges can be compared today. And since higher charges represent a drag on performance – the costlier fund must achieve higher returns simply to match its cheaper rival – the temptation is naturally to favour the low-charging vehicle.

Investment companies have been restructuring and reducing their fees for much of the past decade, ever since the retail distribution review of 2012. Prior to this regulatory shake-up, investment companies had a natural advantage over open-ended funds, which typically paid commissions to financial advisers; once RDR outlawed such payments, open-ended funds were able to reduce their charges and investment companies felt compelled to respond.

We shouldn’t regret the fact that so many investment companies have cut fees or abolished confusing performance-related charges that didn’t always appear to serve investors in quite the way they were supposed to. An industry that was always competitive on charging now offers an even more reasonably priced product.

But does Mr Elliott have a point? As he says, one fund manager did resign from an investment company mandate last year after being told to cut its charges, though the dispute was eventually resolved. Still, there is scant evidence of managers pulling out of the investment companies sector; if they are disheartened by lower charges, they do not appear to be walking away.

What we can say with certainty is that this debate once again highlights the vital role played by the board of an investment company. Remember, closed-ended funds, unlike other investment vehicles, are stock market-listed companies that must appoint independent boards to safeguard the interests of shareholders. It’s a hugely important protection for investors.

With charging, the board clearly has a duty to ensure shareholders are paying no more than necessary for the services of the manager looking after their assets; otherwise, investors would be earning lower returns than they should. But the flip side here is that the board must also be sure it is paying enough to get the best manager for the job. Otherwise, it could also be accused of jeopardising returns to investors.

Not every board will get this balance absolutely right. It’s likely some boards could still negotiate cheaper deals with fund managers; others may have pushed fees too far, putting their investors at risk of the problem highlighted by Mr Elliott.

However, the value of having a board asking exactly these questions is difficult to over-estimate. Investment companies are the only funds where a powerful group of insiders are actively looking out for the interests of investors, weighing the pros and cons of each decision from the shareholders’ point of view, rather than that of the product provider. On the whole, they make good calls – and investors are better off a as a result.