Explaining investment fees to clients

DEBRA SLABBER Business Development Manager, Morningstar Investment Management South Africa

Debra Slabber, Business Development Manager at Morningstar Investment Management South Africa, explains how advisers should tackle the questions around investment fees from clients.

Managing funds and investments require time, money and expertise. As with any service provider, you are expected to pay a reasonable charge for the use of a company’s services. The same rule applies in the world of investments and fund management.

The past decade has been tough for South African investors and, as a result of some anaemic returns, there has been a sharp focus on fees. While it is good to understand what you are paying for when it comes to your investment(s), the cheapest offering is not always the best offering (in Afrikaans we would say “goedkoop koop is duur koop”). So while we would encourage investors to enquire about fees, we would also encourage them not to throw the baby out with the bathwater. Not all fees are bad.

Investors often fret when they look at their fees because the fee terminology can be confusing and the application can be unclear, making it hard for them to make sense of what fees they are paying and (more importantly) why they are paying it. In this article, we unpack some of the fee-related terminologies that a client may come across on statements, fund factsheets and in conversations.

Let’s start with fund factsheets

Most factsheets follow a similar disclosure methodology (and terminology), which makes it easier for clients and financial advisers to compare the fees of the different funds they are invested in and to make a more informed decision. It is important to note that the returns quoted on a factsheet are always net of the Total Investment Charge (TIC), meaning that returns are reported after fees have been subtracted.

Total Expense Ratio (TER):

TER is the global standard used to measure the impact the deduction of management and operating costs have on a fund’s value. It gives you an indication of the effects these costs have on the growth of your investment portfolio. Expressed as a percentage, a fund’s TER is usually calculated over a rolling three-year period. A higher TER does not necessarily imply a good return, nor does a low TER imply a poor return. Also, important to note is that the current TER is backwards-looking and may not necessarily be an accurate indication of the future TER. The TER charge is made up of the following costs:

a) The annual management fee: This is the fee the asset manager charges for managing the fund. The cost varies greatly depending on the mandate of the fund, or rather the type of fund (for example, income funds charge lower fees than a specialist equity fund). This fee is fixed.

b) Other fund expenses: This refers to the operational cost of the fund, including administrative expenses, audit fees, bank charges, custodian fees, etc. This cost is variable but often a small portion of the total cost.

c) Performance-based fees: In addition to earning fixed fees, asset managers may earn a performance-based fee if they outperform a relevant benchmark. The calculation of this varies greatly between different funds and it may or may not be capped at a certain level. Some performance fees are based on a ‘high-watermark’, which means a manager does not earn performance fees unless it is generating new outperformance above the highest previous watermark. This prevents clients from paying for performance more than once, where managers go through cycles of outand underperformance. Not all funds charge performance fees.

d) VAT: Value added Tax of 15%.

Total Investment Charge (TIC):

If you add transaction cost to the TER, you get to a Total Investment Charge, which is the total cost for investing in the fund. Transaction cost is the cost incurred due to the buying and selling of underlying securities in the fund. Transaction cost must always be considered, but within the context of a fund’s strategy, the return being achieved, the amount of trading required, and the amount of risk being taken.

The table below provides an overview of the average TICs per ASISA category.

Next, let’s have a look at client statements:

a) Investment management fee: The annual investment management fee shown is the fund’s latest available Total Investment Charge (TIC) as explained above. Further to this, there may be a separate line item for the Discretionary Fund Manager (DFM) or Category II fee, also often labelled as ‘investment management fee’.

Anyone who manages an investment portfolio must have a Category II financial services provider licence, which requires more qualifications and experience than a Category I licence (which most advisers hold). Advisers with a Category I licence may contract with DFMs to provide investment management services such as asset allocation, portfolio construction and portfolio management. On average, one should expect to pay between 20bps to 30bps for DFM services. (Basis points (bps) refers to a common unit of measure for interest rates and other percentages. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001.)

If an adviser uses a DFM, they should be able to negotiate lower fund fees from asset managers than what a client would typically pay had the client invested directly with the fund manager.

To illustrate this point, the two graphs below show what the total TIC of the various ASISA category averages are, compared to the Morningstar Managed Portfolios total TIC. In all instances, the Morningstar Managed Portfolios are cheaper.

Source: Morningstar Direct as at 2020/09/30. ASISA category average and range based on primary share class for all funds in the category

Source: Morningstar Direct as at 2020/09/30. Global Investment Fund Sector average and range based on primary share class for FSCA approved funds in the category

b) Administrative or platform fee: This is the fee that the platform (also referred to as a Linked Investment Service Provider, or LISP) charges for the administrative duties they perform (for example, for the generation of statements). The platform administration fee varies depending on size and fund or product choice. On average, one should expect to pay about 30bps to 50bps in platform fees.

c) Advice fee: This is the fee paid to the financial adviser. An adviser can either charge on a consultation basis (a fee normally charged upfront), or on an ongoing basis for the management of a portfolio (usually charged as a percentage). On average, one should expect to pay between 0.50% and 1.00% per annum for independent advice.

At Morningstar, extensive research has been done over the years to show that good financial advice can add around 2% per annum in additional returns to investors.

Minimising costs is something we focus on extensively at Morningstar Investment Management South Africa. Price is one of the five pillars we consider when evaluating a fund during the research process. If a fund manager charges higher fees, they will need to demonstrate that their process can produce meaningful outperformance relative to their peers.