Adding value

I was with a client recently and we drifted onto the subject of investment management fees. These are starting to reduce across the industry as the switch to passive funds is starting to bite active managers. His view, however, was clear – cost is the wrong thing to focus on, as it was the end result that mattered.

It is tempting to agree with this sentiment and in other areas of his life this is probably true. No doubt his shirts are more expensive than average but look nicer and last longer (less a small deduction for the cost attributable to maintaining the brand). The same probably goes for his leather shoes, legal fees, accountancy fees and where he lives I imagine the only way to secure a builder or plumber is to pay well over the odds.

When it comes to fund management though there is plenty of evidence that the more you pay the less you get. This is partly a case of fee income being used to pay for expensive advertising hoardings over the concourse at Waterloo station but more so paying for the salaries and bonuses of human fund managers who offer no more return and in some cases a lot more risk than investing directly in the market. In fact research shows that the difference between average passive (computer invested) performance and active (human invested) performance is the average fee of the human.

Active fund management has achieved the impossible by taking a simple process (investing in the whole investable market), overcomplicating to create the feeling that they are somehow needed and then offering a worse version back to clients at a greater cost. This is akin to Aeroflot spending so much on marketing that it is seen as a premium brand and so people pay the highest price to fly with them. The trick is that it is easy to see threadbare seats and grumpy staff but less easy to see if the performance of your investments is not up to scratch.

So if value can’t be added by paying a fee for active management where can you allocate this cost to a positive net benefit?

The first area that is worth paying for (not paying more for but maybe redirecting some of your current active management costs to) is financial coaching to keep you from being a human. Most investors have a much worse investment experience than they ever admit to as they tend to forget the mistakes and over-emphasise the successes. Research from Dalbar Inc since 1976 shows that the average investor experience, measured by the time they invest a fund to the time they exit, is 4.7% per annum (roughly half) worse than the client who stayed in for the whole period (to end of 2016). Investors tend to invest on the back of marketing and get in too late and come out too early. So it is worth paying an adviser to persuade you to stay invested. This unfortunately is a rare skill as advisers are susceptible to paranoia and over-confidence about investments too and far too many also invest based on ‘what did well last year’. Memorably, in a previous incarnation, a project on risk at a major firm highlighted that the risk level of the client portfolio was more correlated to the age of the adviser than the age of the client (suggesting that the adviser’s own naturally waning attitude to risk was influence what was recommended to the clients). So it is worth paying for an adviser that can remain calm and independent minded. This performance enhancement is hard to quantify but the evidence suggests that it is more than can be achieved by active management and so it is worth paying for if the portfolio is big enough.

The second area is tax planning, this is only worth paying for if you have a sufficiently complex set of tax problems. As we have said before on this blog, the less money you have, typically the fewer the tax problems and therefore the less benefit an adviser will be compared with an app on your phone. We suggested £250,000 and below is a good cut-off for sacking your adviser but a couple with £500,000 or less in ISAs is probably equally well served by a phone app. If there is inheritance tax, capital gains tax , corporation tax or income tax that can be saved in substantial enough an amount, then this is worth paying for. Tax savings are easier to quantify and therefore easier to compare against the fees paid to achieve the saving. Always ask what you are paying for (hopefully you already know what you are paying). If the answer is performance, outperformance, risk management or any other buzz word to do with investments then you are probably overpaying. If the answer is behaviour coaching and/or tax planning and this is the % difference we have made, then fair enough.

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