Leading the charge against high cost funds

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The Independent Online

This week I want to offer more thoughts on the subject of fund management performance and costs, about which there now seems to be a healthy, and long-overdue debate developing in the investment industry. But the cause of cheaper financial services has hardly taken the country by storm. I see little prospect of a nationwide march by irate fundowners and mortgage-holders, descending on London to demand better terms and conditions, splendid though that might be as a spectacle.

This week I want to offer more thoughts on the subject of fund management performance and costs, about which there now seems to be a healthy, and long-overdue debate developing in the investment industry. But the cause of cheaper financial services has hardly taken the country by storm. I see little prospect of a nationwide march by irate fundowners and mortgage-holders, descending on London to demand better terms and conditions, splendid though that might be as a spectacle.

But there is quite clearly greater awareness and mounting evidence to demonstrate that this cause, long championed in this column, is spreading. I offer these three further pieces of evidence in support of the proposition that we are moving slowly but surely towards a world where investors, investment managers and advisers give much greater credence to the impact of costs on long-term investment performance.

The first is the experience of John Neff. I recently had the good fortune to spend some time talking to this well-known American fund manager, who is retired and visiting London to promote a book about his experiences ( Neff on Investing).

The name may not mean much to you, but to cognoscenti of the fund management business, John Neff is right up there alongside the few real superstars of the postwar era. He is one of the few investment managers to have consistently outperformed the market over the long term.

The track record of the Windsor Fund, which he ran from 1964 to 1995, stands comparison with that of Warren Buffett and Peter Lynch, outperforming the market by 3.1 per cent over the same time frame, a remarkable achievement in a business where success can normally be measured in fractions of a percentage point. This record owed much to the steadfastness with which Mr Neff stuck to his philosophy of contrarian value investing, which was based on buying out-of-fashion stocks and making big bets when he felt the circumstances justified.

The important point for our purpose is not to explain why and how John Neff compiled this track record, but to record the equally remarkable, by industry standards, basis on which he was paid. He was paid an annual performance fee of just 16 basis points (0.16 per cent of funds under management) throughout his long career. If he beat the S&P 500 index, his benchmark, by more than 4 per cent a year, he received an extra 10 basis points - and if he fell short of the index's growth by a similar margin he had to give back 10 basis points to his investors, leaving him with just 0.06 per cent as a fee. What the investor actually paid, including administration costs, was an annual charge of 0.35 per cent. Contrast this with the average unit trust in this country, which charges you several times as much (1.25 per cent a year), takes your money whether it beats the market or not - and 80 per cent of the time fails to outperform its equivalent index over periods of more than 10 years.

The moral? There are two. One is that you do not have to be paid a fortune to manage a successful actively managed fund, nor to get rich by doing so. (Of course, John Neff is not short of a dollar or two, but has the satisfaction of knowing that he has earned his rewards). The other is that it demonstrates how important low costs can be in any long-run performance track record. Had Mr Neff charged the industry average annual management fee, the chances are he would not today be lauded as a superstar.

The second piece of evidence is supplied by Norwich Union, the insurance company/fund manager, and Fitzrovia International, the independent research firm whose findings on fund management costs I have mentioned before.

Last week, these two firms launched a novel market index which is designed to measure the performance of CAT standard funds against those which do not meet the CAT standard criteria. (CAT standards, you will recall, are the Government's heroic attempt to encourage simple, low-cost standardised products in fund management and also, it now seems likely, in mortgages.)

What the index shows is, so far, very much what you would expect. The figures supplied by Fitzrovia (which I have seen and been able to analyse in detail) demonstrate that CAT standard funds as a group are performing almost exactly in line with non-CAT standard funds as a group before all expenses, but doing significantly better after taking account of the bid/offer spread and all initial charges.

These are still early days - CAT standard funds have only been going since April - but by the end of October, after seven months, there is absolutely no evidence to support the view that the higher charges of the non-CAT standard group are being rewarded by better performance. This is as true of actively managed funds as it is of index funds, which make up about half the total of the CAT standard group. What is striking is that if you compare the performance of CAT and non-CAT funds on an offer-to-bid basis, over seven months the gap between the two after charges is just as wide in nearly every sector as it was at the outset.

The third piece of evidence comes from John Chapman, a former government official whose studies of pension plan costs have been published by The Independent. He has now extended his analysis from pension funds to equity unit trusts, and come up with a remarkably similar conclusion - that there is no discernible relationship between fees charged and performance achieved. (The analysis is reported in the September issue of the trade magazine Money Management, for those who want to see it in more detail.)

The figures are not easy to follow, but what they show is how the performance of funds varies with the level of charges levied on consumers. If high charges were justified by superior performance, you would expect to find that performance improved the higher the charges. Again, there is absolutely no evidence of this in this analysis, which covers the period 1994-1999.

An interesting sidelight that also comes out of Mr Chapman's analysis is that the link between performance and charges is, if anything, becoming even less clearcut than it was. This is consistent with the thesis that, since performance figures become so much more widely available, the scope for indifferent funds to get away with charging excessive fees for inferior performance has diminished.

I think this trend will continue. In a more transparent and low-return world, high charges are bound to come under further pressure. It is right not to be too complacent about this trend being unequivocally good. It may be that as charges come down, the rewards to fund managers will also come down. And if this is combined with a prolonged equity market setback, it will undoubtedly lead to some exodus of talent from the mainstream fund management industry (as is already happening to some extent with hedge funds).

It is certainly not the case that price is everything in this business either: it seems obvious that quality of service is also going to become an increasingly important element. But, given how profitable the business of fund management is already, I do not think we need to shed tears just yet for those who toil hard to emulate John Neff's performance, at the same time trying equally hard to avoid being paid on a similarly tough basis.

Davisbiz@aol.com

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