News that Standard Life Investments plans to increase its annual management charge on seven funds in November caused something of a furore in social media cycles Thursday, not least on Twitter, with advisers and financial journalists alike deprecating the fund house for depriving investors of their assets’ hard-earned gains to line their managers’ pockets.
Fund fees are something of an obsession at Morningstar. We’ve carried out endless research into the impact of fund fees on investor returns and know only too well that funds are one of the few areas of life in which paying more rarely gets you a better product. Fees cut into performance in a big way over the long term, hence why we pay such close attention to costs—not just annual management charges but the total expense ratio incurred by investors—in our Morningstar Fund Research.
As you might expect, news of imminent fee hikes sets our alarm bells ringing. There are several reasons for this: First, investors in the U.K. pay extraordinarily high fees relative to investors in the U.S., and even relative to other European markets.
Second, the price increase highlights that investors in the U.K. have no protection against such rises: the fund companies can raise fees when they like as there is no independent board of directors to negotiate on behalf of investors. That contrasts sharply with investment trusts, which have independent boards (indeed, the closed-end version of one of the affected funds, Standard Life UK Smaller Companies (SLS), charges a management fee of just 0.65% (plus performance and additional fees) and a TER of only 1.19%). In the U.S., independent directors negotiate fees with the manager on behalf of shareholders and must provide written justification of the fee level in every annual report. Indeed, it was only five or so years ago when most of the big houses in the U.K. moved their management fees in lockstep from 1.25% to 1.50%. While investors can sell and buy a cheaper fund, doing so might force them to realise a capital gain and there are sales charges associated with buying a different offering, so this is no real protection.
Third, as trail commissions are meant to go away under the Retail Distribution Review, fund companies will be able to keep more of the management fee for themselves—indeed, we expect fee reductions under the new regime, not fee increases.
Putting Fees Into Context
There are seven funds at Standard Life due for cost increases in November: annual management charges for Standard Life Corporate Bond, Global Index-Linked Bond, Higher Income, Select Income and UK Gilt are due to rise by 5 basis points from 0.95% to 1.00%. Standard Life Global Equity Unconstrained and UK Smaller Companies will see their AMCs upped by 10 bps from 1.5% to 1.6%.
A knee-jerk reaction to such changes, as seen in the press and online forums yesterday, is wholly understandable. But it’s important to look at such hikes in context. Firstly, it’s important to look at the TER rather than just the AMC, thus taking into account marketing spend and initial fees. Secondly, it’s important to compare such costs to each fund’s category average. And thirdly, it’s important to look behind the scenes at why the fees are being increased.
Morningstar Direct data shows that of these seven funds, two—UK Gilt and Global Equity Unconstrained—already carry TERs above their IMA sector averages, while the other five currently cost less than their sector average.
Applying the relevant 5bp and 10bps increases across all seven funds doesn’t appear to warrant quite the vehement online reaction that the news triggered on Thursday, when compared to similar funds from other providers. Certainly fee hikes are never desirable, and the two relatively expensive funds in question will become increasingly so in November, but three of the funds—Corporate Bond, Select Income and UK Smaller Companies—will remain broadly in line with peers, while the remaining two—Global Index-Linked Bond and Higher Income—will still 14 bps and 20 bps less than their IMA sector averages, respectively. A rather rudimentary traffic light system highlights these relationships in the above table.
Red Flags
Morningstar data highlights two red flags. The first is Standard Life’s UK Gilt offering, which after the fee hike will cost a whopping 50% more than the IMA sector average and looks even more expensive compared to its Morningstar GBP Government Bond category median. “Standard Life UK Gilt has a current TER of 1.06% and the new TER would push fees across the 1.09% threshold of the most expensive quintile of funds in the Morningstar GBP Government Bond category,” comments Morningstar fund analyst Oliver Kettlewell.
Higher expenses erode returns over the long term and are particularly important in bond funds where returns are more constrained to begin with. Further, an expensive bond fund in the current income environment is particularly undesirable. Investors (or prospective investors) in these funds may want to use Morningstar’s Fund Compare tool or new Premium Find Similar tool to investigate alternative investments.
Solid Funds at Competitive Prices
That’s the bad news out the way. Standard Life UK Smaller Companies is perhaps the one fund of the bunch that has attracted the most attention in the last 24 hours. This fund carries our analysts’ highest qualitative rating, Elite, thanks to its numerous positives: long-serving manager Harry Nimmo, backed by a strong team dedicated to small caps, a disciplined process that has stayed true to its aim, an excellent long-term track record, and a competitive price tag. A 10bps fee hike will see the fund cost just 2 bps more than its IMA sector average. It’s here that it is perhaps most pertinent to ask why Standard Life is increasing its fee.
The act of raising fund fees is sometimes used by asset managers as a means of curtailing asset growth in their most popular funds and, in the case of Nimmo’s UK Smaller Companies, Standard Life had intended to close the portfolio to new investment at the end of June but this date has been pushed back to end-August. The question prospective investors should be asking themselves here is whether this is an attempt to ‘soft close’ the fund and, if so, whether hard closing it would potentially better serve clients’ interests.
The fund’s assets under management have increased dramatically from £0.5 billion as at June 2010 to £1.3 billion as at May 2011. “Growth in assets can be particularly problematic for fund managers of small-cap funds because of the lower liquidity associated with smaller-cap stocks,” notes Morningstar’s Kettlewell. But shouldn’t a swell in assets enable the fund provider to reduce its management costs? This is certainly a trend noted in the U.S., where some fund houses automatically reduce costs when assets exceed a pre-set level. Alas, this is far from the norm in the U.K.
Turning to the final offerings that remain on the good value side, Standard Life Global Index-Linked Bond fund and Higher Income fund will be priced at 14 bps and 20 bps less than their IMA sector averages, respectively, come November. The latter carries Morningstar’s Superior qualitative rating.
Can Fee Hikes Ever Be Justified?
It’s worth noting that higher management fees aren’t always the stab in the back that fund investors might consider them to be. Certainly lower fees are desirable in ensuring that investors reap the most of their investments’ rewards. However, fees can occasionally be justifiably increased when done so alongside an increase in the fund’s resources, through additional analysts or fund managers. “In such a case, the greater research team could then be better placed to produce higher returns, thereby recouping the topped-up fees,” Kettlewell points out.
The imminent changes at Standard Life are by no means an exclusive case. It is one of many examples of shareholder-unfriendly moves and lacking investor protection. Indeed, Henderson Global Investors confirmed this week that it will be raising administration charges on 30 funds at its Gartmore subsidiary to bring them in line with fees at Henderson. Unfortunately, U.K. investors continue to be lumbered with high fees relative to their U.S. cousins, as highlighted most recently by Morningstar’s 2011 Global Investor Experience Study. It is little wonder that exchange-traded funds and low-cost actively managed funds are increasingly popular.
All in, Thursday’s commotion may have been something of a knee-jerk reaction to a solitary news item but it acts to highlight the importance of fees when it comes to investing in funds. Morningstar.co.uk fund reports contain fee information on thousands of funds—OEICs, closed-end funds and ETFs—for individual investors and their advisers to analyse. Rest assured, Morningstar will continue to campaign for fair and low level fees and full transparency in the disclosure of investor costs.
Christopher J. Traulsen, Morningstar director of fund analysis in Europe and Asia, contributed to this article.
