Methodology Note
We restricted the universe to offerings lega
lly domiciled in each of the two markets, and compared all the funds in the Morningstar UK Large-Cap Blend, UK Large-Cap Value, and UK Large-Cap Growth equity categories to their US equivalents (US Large-Cap Blend, US Large-Cap Value, and US Large-Cap Growth). We looked at all share classes of funds with minimum investments below 50,000 in each market's local currency. Finally, unless otherwise noted, we permitted multiple share classes as each class represents a viable option to retail investors, and our goal was to look at the fee distribution across all investable offerings in the universe in question.
Industry Still Stuck on 1.5% AMC
It will come to no surprise to UK investors that the median annual management charge for the funds we considered weighs in at a hefty 1.50%. Indeed, many of the largest houses have increased their AMC to this level over the past 3-4 years. If we break it down on a percentage basis, 57% of the UK fund classes we examined charged 1.50% for an AMC, and no other 10 basis increment from 0 to 2% captures any more than 14%. That's an enormous amount of funds clustered at a given level, and suggests that either there is perfect competition and that fund companies are price takers, or that fund companies simply don't need to compete on price. The former is clearly untrue: fund companies have been enormously profitable, and investors don't focus enough on price or have enough ability to easily switch among products for this to be the case. The latter seems much likelier--indeed, it's taken as a truism in the industry that retail funds have higher profit margins than institutional business.
In contrast, in the US market, the median AMC is just 0.67%, less than half the level in the UK. Further, the distribution of management fees is much broader across different levels. This suggests that funds there are--at least in some cases--competing on price. As funds grow, for example, they can afford to lower their management fees and still grow their revenue streams rapidly (asset management is nothing if not a scalable business), so one would expect larger funds to have lower fees, which they do.
UK Total Expense Ratios Higher
AMCs only tell part of the story, however. The best measure of ongoing costs is a fund's total expense ratio, which includes most operating and admin costs, with the exception of trading costs and borrowing costs. Here, we looked at the cheapest retail class of each fund, in order to isolate the lowest ongoing cost at which an investor can own a fund. On this basis, the figures again show that UK funds are substantially costlier than US-based offerings. The median TER for the UK universe is 1.58%, whilst the median TER for the U.S. universe is just 1.16%. Sixty three per cent of the U.S. universe carried TERs below 1.25%, compared to just 25% for the UK universe. As with AMCs, the U.S. universe also shows a much broader spread of TERs than does its UK counterpart.
There are several possible contributors to the stubbornly high costs of UK funds. First, the market is smaller than in the US, and funds do not enjoy the same economies of scale. This owes partly to the failure of UK and European markets to come together to form a true pan-European fund market without local barriers to entry. The issue goes beyond scale, however. Unlike the U.S. market, few, if any UK funds reduce their management fees as asset under management rise. In other words, even if they were able to gather more assets, there's no indication at all that fund companies would pass along the cost savings that come with running larger pool of assets to investors. They haven't thus far.
In contrast, it's common for U.S. funds to specify a clear reduction in fees as assets grow. This is most often done at the fund level, but some large groups use their total asses under management to dictate the fee. Fidelity, for example, divides the management fee for each its funds into a basic fee and a group fee. The basic fee doesn't change, but the group fee can run from 0.52% to 0.2407% depending in the group's assets under management. Thus, the management fee for a fund with a .20% basic fee, might run from a high of 0.72% (if the groups total assets under management were low), to a low of 0.4407% (if the group's total assets under management were very large). The arrangement makes tremendous sense: In asset management the revenue from management fees rises much, much more quickly than costs as the assets of a fund grow. Consider a fund with £500 million in assets that charges 1.50% in AMC--that's £7.5 million in annual revenue to the fund company. Now, if that same fund grows to £3 billion, it will generate revenue of £45 million, but the costs of operating the fund are unlikely to increase by anything like that amount--a fund company can still realise massive increases in revenue and profitability, even whilst scaling fees back as assets grow.
Who Fights for the Investor?
An issue at least as important as scale in our view is corporate governance. In the UK, the board that oversees funds can consist of a single corporate entity, the fund company itself. In the U.S., at least 75% of a fund's board members must be independent of the fund company. The independent directors alone negotiate fees with the fund company, and they are charged with acting in the best interests of fund investors. Further, they must justify the fees, in writing, every year. The upshot is that in the UK, fund holders have no one to argue their case--when it comes to fees, fund companies are in the ridiculous position of negotiating with themselves. In the U.S., however, the independent directors can serve as a brake on over-reaching and over-charging by the fund company.
Fee Disclosure: Improving, But Regulators Need to Do More
Another big part of the problem has been disclosure. For years in the UK, funds' TERs were not required to be disclosed. Whilst AMCs were usually available, they do not tell the whole story: Indeed, funds with the exact same AMCs can have wildly different TERs. For example, both Jupiter Global Technology and Rensburg UK Blue Chip Growth have annual charges of 1.5%. However, the Jupiter offering's TER is 1.83%, whilst the Rensburg offering's is 1.56%.
Thanks to UCITS, TERs are now disclosed in funds' simplified prospectuses, but even now, funds often cite only their AMC when they launch and in their monthly fact sheets. This strikes us as patently misleading: it implies that there are no other charges, or at least that it's a valid measure of cost, but as we have seen, that's not the case. If the FSA were to mandate that fund companies had to prominently disclose their TER on all marketing materials, the issue would be easily resolved.
Finally, we'd be remiss if we didn't mention the fund distribution system and the impact of trail commissions (which the end investor has no ability to negotiate) in TERs. In this regard, the RDR may help address some of the factors that have pushed up costs. Of particular concern, however, is the life and pension arena, where charges are opaque and tend to be considerably higher than those imposed by the underlying fund. Again, the FSA should step in--these vehicles represent a huge part of UK savings, and they should be required to disclose their "all-in" TERs in a clear, easy to understand fashion.
A version of this article originally appeared in Fund Strategy.
