Dr Nick Motson of Cass Business School has issued another broadside at the funds industry who have been dilatory at best in responding to consumer pressure to better align its fees to the value it brings to consumers.

Cass’ idea is a simple one, fund managers would be paid on performance against what they said they would do. A sophisticated version of “no-win, no-fee”. The argument is that the good ones would be paid more and the poor ones less. The poor ones would have to leave the market- to everyone’s relief.

But it’s not as simple as that is it Justin?

Listening to Radio 5 live, I heard my red braced school-chum Justin Urquhart-Stewart defending the fund industry’s practice of charging people a % of funds under management rather than linking fees to the performance or underperformance of the fund – relative to what that fund set out to do – e.g. the benchmark.

This is of course, entirely missing the point – deliberately some would say!

Fund managers can (and should) be paid performance fees even if the fund shrinks!

The example was given of a fund manager investing in Japan who would have seen his fees fall over 20 years because of the capital losses in the Japanese Stock market. As I understand it, an active fund manager who had seen a fund fall by less than the benchmark (typically a Nikkei index) – would get paid more than a passive manager who just delivered the market return. The example is again irrelevant.

The point of aligning fees to performance against the stated aim of the fund is that it does not reward the 80% of active managers who consistently fail to bring home the bacon and bring some risk to the business of active fund management – to the managers!

But active managers should not be rewarded for not doing what they said they would

At present, anyone can set up as an active manager and charge high fees (1.5% of the fund is typically quoted as the RRP). But so long as the fund continues to benefit from the support of its uni-holders, the manager continues to rake it in whether he or she does well or badly.

Which makes for an appalling lack of incentive on the manager to perform. It makes for lazy behaviour (see the stuff below on charges) and it makes for a culture where the creature comforts of managers come before the returns of the investors

On the radio, the question was asked –

“why do investors stick with active fund management”.

The answer may lie in the difficulty of moving money, it may lie in the expense of moving money and it may be because investors are trying to buy and hold- as Warren Buffett tells them to.

Whatever the exact reason, investors are doing for fund managers, what fund managers need and want, giving them the long-term horizon to buy and hold for value. The question we should be asking active  managers is why they are doing so little to reward the people who are being loyal to them.

One thing that is for sure, is that all the cards are in the active managers hands and we can see (below) that the active managers are not too keen to show their hand to people who ultimately own the money.

This is known as fund management’s “asymmetry of information”.

Justin blithely spoke on Wake up to Money this morning about the days when fund managers were obliged to churn their portfolios every year to generate extra commission for the managers. Apparently these days are gone. This was another (successful) ruse of Justin to throw the pursuing journalist off the scent.

For, within the past two years, research by Dr Chris Spiers, the new MD of KAS Bank, showed some active fund management houses were still churning portfolios to a point that it was nigh on impossible to justify the transaction costs involved by the potential for higher performance.

Not only was Spiers’ research suppressed, but the fund management industry, led by the Investment Management Association, continue to suppress information on the portfolio turnover rates  (churn rates) of active funds.

Performance fees and full cost disclosure go hand in hand

The issues of linking active performance to fund management charges and the disclosure of the true costs of investing are co-joined. Many active managers have such high transaction costs (resulting from poor execution and over-trading) that they become serial underperformers no matter what the skill of the managers. It’s like trying to win a horse race with Fatty Arbuckle on its back!

For the fund management industry to own op to the true costs of active management, it would have to expose itself to the criticism of the journalists on Wake up to Money that allowed Justin to kick the issue into the long-grass.

There would be nowhere for fund managers to hide.

Asset managers should be required to reveal the full costs of active fund management to help investors see the full drag on their returns.

The Pensions Institute at Cass Business School has published a white paper calling for asset managers to disclose all visible and hidden costs which are ultimately borne by investors.

Research cited in the paper suggests that concealed costs – such as bid-ask spreads and transaction costs in underlying funds – can make up to 85 per cent of a fund’s total transaction costs. The remainder is taken up by visible costs such as commissions, taxes and fees.

Director of the Pension’s Institute, Professor David Blake, said: “No good reasons have been put forward for why all the costs of investment management should not be fully disclosed. They are after all genuine costs borne by the investors.

“There is little point in requiring transparency where the reported measure for ‘costs’ does not include all of the costs, or in the short-term, as many costs as could currently be reported on an efficient basis.

“If total investment costs are not ultimately disclosed in full, how can there ever be an effective and meaningful cap on charges, and how can active investment managers ever asses their true value added?”

Costs could be reported in the form of a ‘rate of cost’ – which could be deducted from the gross rate of return to give a net rate of return – and as a monetary amount, which could be compared with the monetary value of the investor’s portfolio.

The paper suggests a staggered approach could be taken in the lead up to the full disclosure of all transaction costs.

In the initial stage, investment managers should be required to report all visible cash costs involving commissions, taxes, fees, custodial charges and acquisitions costs, together with the hidden cash costs of bid ask spreads, transaction costs underlying funds and undisclosed revenue.

“All these indirect costs relate to the efficiency of the investment management process and all good investment managers should have an estimate of their size,” said Professor Blake.

Once investment management firms have the right IT systems in place, non-cash costs should also be reported comprising of market impact, information leakage, market exposure, market timing costs and delay costs (see below).

Professor Blake added: “The hidden non-cash costs would be more challenging to calculate, since they involve the analysis of information that might not necessarily be automatically captured by the investment manager’s own systems. Nevertheless, the issue is whether fund manager systems could be configured to generate similar information on a cost-effective basis.”

Visible cash costs