This week I’m featuring a number of articles by my friend and mentor Con Keating. You may not understand all of this as it is written for a specialist audience (too rarified for me at times!). But the bottom line is that Con knows his stuff and is not afraid to say it as it is!
The debate over the disclosure of costs and fees for investment portfolios has been long, often obscure and even occasionally bad tempered. It seems likely that the current interest of the FCA and other official bodies will bring to an end the prevarications, obfuscations and misunderstandings so that meaningful disclosure may become the order of the day.
It is worth understanding the magnitude of fee effects in portfolio management – a 2% fee based upon the value of a portfolio (ad valorem) is equivalent in effect to 20% volatility or risk in the portfolio. Twenty percent is, of course, the order of magnitude of risk or volatility of equity market portfolios.
There is also a hidden sting in the tail. A 2% ad valorem fee applied to the period end portfolio will also capture a proportion of the portfolio’s return over that period. Let us suppose that the portfolio returns 5%, then the fee amounts to 2.1% of the period’s initial value. The situation get worse as we move into period two, with the higher opening of period capital value (102.9 after fees) and again a 5% return, the fee rises to 2.16% of the initial capital value. After two years, this simple 2% ad valorem fee has left only 57% of the total available value added for an investor, and it continues to decline. The fund manager charging this type of fee is getting repeated bites at the same performance cherry.
More egregious is the practice that has developed of levying addition costs and charges in addition the stated management fee. These can be substantial indeed. Of particular concern, and likely to grow now that research will be unbundled from execution costs, is the practice of funds being charged for research – the simple argument is that these expenses should surely lie with the fund manager as they form part of the intellectual property of the fund manager that supports the service they offer and charge for.
Since the work of Chopra and Ziemba in the early 1990s, we have known the relative magnitudes of changes in the mean return, variance and diversification (correlation) parameters of portfolio asset allocation optimisation routines. Changes in the mean return are at least an order of magnitude more important than changes in volatility or correlation coefficients, and of course, costs and fees are first and foremost changes in returns. There are some important lessons to be taken from this fact; for example that there are many investment strategies, which though potentially justifiable using diversification arguments, that make no sense after consideration of their costs and fees.
Charles Ellis, a legend in fund management circles, has long argued for fee disclosures to be based not on the portfolio value, but upon the return achieved by the manager of the portfolio; the argument is simply that this is what the manager is trying to achieve, a value added given a particular pool of wealth to manage. In implementation, the fee is reported as a proportion of the return achieved – a five percent return and 2% fee would show the fee as 40% of the return. That simple shift does more to domesticate hedge fund fee structures than any other.
There are however two issues with this: the first is that, in the long-run, the real equity return reduces to dividend income, and the added value, if any, of an active equity fund manager is only a small proportion of the total return. The first of these argues for reporting fees as a proportion of the portfolio income, though income is an easily manipulable metric, and the second argues for fees to be reported as a proportion of the investment manager’s value-added, rather than total return achieved by a manager.
Value for money evaluations are simple exercises when fees are expressed in terms of returns, though they do require the use of benchmarks. Suppose a portfolio benchmark exists and that it returns 4% and incurs costs of 0.5%, then we see immediately that the manager is charging 1.5% in fees to deliver 1% in return performance – scarcely a situation that should be allowed to continue.
There are still many who contest the feasibility of comprehensive performance reporting; their arguments are that there are many unobservable implicit costs, such as those arising from transactions as principal with market makers. The reality is that the Dutch regulator already requires comprehensive reporting of investment costs and fees, albeit that principal to principal transactions have imputed costs. In fact, it is possible to estimate the aggregate of these “hidden” costs by comparison of the portfolio outcomes with a passive benchmark – indeed that benchmark could be the initial portfolio allocation, which would offer insight into the effectiveness of all subsequent trading activity.
Portfolio turnover is an important contributor to management expenses. Turnover is also a good guide to the investment horizon to which a portfolio is being managed. Portfolio turnover is simply a matter of the sales and purchases made within a period, though complicated by the flows of cash into and out of a portfolio. Indeed even the simplest portfolios usually experience such flows if only from the dividends, coupons and maturing proceeds of investments. However, the techniques for dealing with such situations are well known from experience with pooled funds.
Contrary to the beliefs of many, it is not necessary to invoke the elementary theory of the capital asset pricing model, with its alpha and beta. The comparison of distributions of portfolio returns can be effected by affine transformation (that is to say translation and rescaling) of those returns such that they occupy the same range of support.
Tracking error has found favour as a risk measure in portfolio management. In its original use with passive index funds where there was no expected deviation in return from the benchmark, its definition as the standard deviation of the returns of the differences between the portfolio and the benchmark was correct. However, when applied to active management where the objective is to generate a return in excess of the benchmark, then the calculation formula needs to be extended to accommodate the difference in returns. Not surprisingly, this measure of tracking error is strictly higher than the measure currently in use.
In fact, if a measure of portfolio risk is required we need go no further than the difference between the arithmetic average of the returns and the geometric average return – and we will see that a 2% difference between the geometric and arithmetic average return indicates a portfolio risk of 20%.
Ending here, with no discussion of derivatives might seem like a cop-out, but other than for the costs of collateral management, their reporting is fundamentally no different from elementary securities. Collateral management, including activities such as repo, really present no significant new challenges. Perhaps the greatest challenge is how to handle outstanding recoveries of taxes withheld, which may require an opportunity cost approach.
This post first appeared in Professional Pensions http://www.professionalpensions.com/professional-pensions/analysis/2422857/transparency-must-go-beyond-costs-and-fees