Many investment reports caution that, due to current investment markets, South African investors are unlikely to continue to achieve the same excellent returns that we have benefited from over the last few years. This means that when we make an investment we need to be aware of everything that could negatively influence our potential return. In other words, every penny counts. While cost does influence our “after-cost” return, it is important to understand what kinds of costs we should expect to pay and what cost parameters are considered fair.
How much focus should we place on costs in our investment decisions?
Taking costs into account is important, but I would caution against allowing cost to be the key or deciding factor in your investment decision. You could end up paying lower costs for an inferior product or investment manager.
Instead, for a slightly higher cost, you could purchase a much better product, or the services of an investment manager with a far better track record and the ability to perform and generate a good long-term investment return after their costs. But if you are weighing up two investment managers with the same return profile and the one is charging double what the other is charging, then you should ask why.
What are the costs that individual investors can expect to pay?
In general, you should expect to pay a fee for the different professional services you receive. These typically include:
- financial adviser fees for financial advice and investment support;
- an investment management fee for investment management; and
- if as an individual investor you invest via a linked-investment services provider (also known as a fund platform or LISP) that aggregates your investments and provides you with consolidated statements, you could be required to pay an administration or platform fee for its services.
Understanding our unit trust fees at Prudential Portfolio Managers
When you invest with us, you pay two fees
In the table below, the initial and ongoing fees are categorised and named according to who is paid. We normally quote the fees in our communication, excluding VAT.
Initial fees are deducted from your initial investment amount before we invest your money. The initial financial adviser fee (also known as an initial IFA fee) is a fee that you agree with your financial adviser at the time the investment is made. We do, however, apply upper limits to this when you invest with Prudential. According to these limits (which vary per type of fund), the maximum initial financial adviser fee is 3% of your initial investment. Prudential does not charge an initial fee.
Ongoing annual investment management fee
The annual management fee includes both the fee payable to the financial adviser and to the investment management company.
If the annual management fee is 1.25% and the annual IFA fee is 0.5%, it means that the investment management company will receive 0.75% and the financial adviser 0.5%. We encourage you to get objective financial advice from an independent financial adviser. They are best equipped to understand your needs and objectives and help you decide on an appropriate investment to meet these.
We believe the adviser plays a critical role in agreeing your long-term financial goals with you, not just in matching you to a financial product from time to time. If, however, you decide that you prefer to invest without the guidance and support of an adviser, Prudential takes on the additional operational servicing and support function that the financial adviser would normally provide, which accounts for the fee structure.
We may not, however, provide you with advice or guidance on your investments. Only a licensed financial adviser may provide you with advice (determine your investment goals and advise you on which product may or may not meet your individual needs).
For example: If you invest R10,000 and the annual management fee is 1.25%, the total annual fee amount is R125 (before VAT). When this fee is spread across 12 months, the monthly deduction will be R10.40. The fees are based on the value of the assets under management. This means the fees will change as the asset value of the investment changes. If, in the case of the example above, the asset value increases to R11,000, the total annual fee amount will increase to R137.50 (1.25% of R11,000), and the monthly deduction will increase to R11.45.
Some funds have a performance fee included in their structure. These reward good performance and penalise poor performance. We will deal in more detail with performance fees in a subsequent publication, but I briefly comment on the subject later in this article.
It is easy to see with hindsight how fees have affected an investment return but this is usually too late. How do you recognise a fair cost before investing that will not erode the hard-earned returns in an unreasonable manner?
In terms of fairness, I would argue that over time, looking at a multi-asset class fund (one that invests in say equities, bonds and cash), if one takes into account the adviser, investment manager and platform fees, ideally you do not want to be paying more than between 1.5 and 2% per annum. As soon as you are paying more than that, it becomes progressively difficult to absorb that fee over time. In relative terms, make comparisons between like funds. Ask the question, “How does it compare to similar funds in the same asset class or category?” You should also compare the fund’s pattern of return through market cycles and not just over the last 12 months before you decide whether it is cheap or expensive.
How should an investor analyse the cost of an investment and are they currently doing this?
Just to recap: When it comes to investing in a unit trust with an investment manager such as Prudential or if you invest in a unit trust via a LISP or investment platform, there are three possible fees:
- The adviser fee, which may or may not be built into the return. If you purchase a unit trust directly from an investment manager (via an adviser), it is likely that their fee will be included, but if you purchase a unit trust via a platform, the fee may not be included.
- The investment management fee, which is built into the ongoing return (so the return the unit trust gives you is net or after that fee).
- The LISP, or platform administration fee – where you decide to buy a group of funds and mix them together, and you want a platform to aggregate these for you.
The total of the three potential types of costs or fees should not be more than 2% per annum over time. If it is significantly above 2%, you may have a situation where the return being generated is being eroded so much that you are not left with any meaningful residual return. I use 2% loosely, but I feel you may struggle to recoup any costs that are significantly above that level.
How should we be using Total Expense Ratios (TERs)? What are their advantages and limitations?
Please refer to “Understanding Total Expense Ratios (TERs)” to learn more about Total Expense Ratios. When evaluating costs using TERs, you can do so in absolute or relative terms. In absolute terms, you would look to see whether a TER is high or low, and in relative terms, you would compare the TER of similar funds. You cannot compare a TER of an equity fund with that of a bond fund, for instance. They will be different, and they should be, but you could well compare the TER of two equity funds.
In absolute terms, a TER below 1% per annum is a low TER, particularly in an equity, or any multi-asset class fund. If it’s between 1 and 2%, it’s acceptable. If it is above 2%, warning bells should start ringing. In this case, the manager would need to produce quite significant excess return or alpha to absorb those fees. That’s not to say that if a TER is above 2% it is definitely a bad fund; it just means that one would need to scrutinise it quite carefully, looking at the fund’s track record to see whether the high TER is justified.
How should we compare costs when looking at fixed-fee products versus performance-fee products?
If you are investing in a unit trust, this is done nicely for you in the TER, which shows all the ongoing fees associated with that unit trust. If there are adviser and platform fees outside of it, they may not be included, but all the actual unit trust fund fees are contained in the TER. The TER is the best and most comparable way of encapsulating the cost of investing via that fund.
A high TER does not necessarily mean that that fund is worse than a fund with a low TER. The question is what excess return has the fund given over time? If that high TER fund has given phenomenal returns, you may find that your net returns are better than the fund with a low TER. So don’t just compare high and low. You need to interrogate the TER versus the return profile of the fund. In the case of a unit trust, both fixed and performance fees will be contained in the total TER.
If there is a performance fee element, this will be itemised within the TER (TER of X including a performance fee of Y).
There is huge debate around whether a performance fee is good or bad. I don’t think you can answer that with a simple “yes” or “no”. The key questions are: are they fairly structured and is the way they are charged clear? Is there a high-water mark (which controls when performance fees can be taken)? Is there a maximum fee? Is there claw-back (if a manager is underperforming, does he pay you back)?
You need to consider all of these factors. The critical issue is, if there is going to be a performance fee, it needs to align the interests of the manager with the interests of the investor. I can see a place for a performance fee in an equity-type fund that is aimed at outperforming the market, but I think as soon as you get into target return-type funds, or funds that try to beat inflation, it becomes a little bit less clear that performance fees are in the interest of the investor.
How much extra cost can be incurred by excessive investment switching?
I would battle to put a number to it, but the key issue here is the opportunity cost rather than the direct cost. Since 1994, DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) has been measuring the effects of investor decisions to buy, sell and switch into and out of funds over both short- and long term time frames. The results consistently show that the average investor earns less – in many cases, much less – than fund performance reports would suggest. Investors who switch regularly, typically lose. So while the fees for switching between funds are almost non-existent, the thing to be aware of is opportunity cost. What have you left on the table? What have you missed by trying to time the markets?
In summary, at Prudential, in line with our prudent value investment philosophy, we believe that price is an important factor, but it is only one part of any investment decision. What is more important is the value that one gets for the price you pay. Investors should speak to their financial adviser about investment costs when they make an investment decision. However, it is very important that the conversation is about value for money to ensure that they make the best long-term decisions in line with their long-term goals.