Costs, Fees and Commissions – how do these impact your investment?

There has been plenty of press over the years on how high fees can impact on your investment – and has led to the trend toward ETFs, Trackers and DIY stock portfolios. It’s interesting to look back at the way the average person invests and how that has evolved over the decades.

Before 1965 in South Africa (when the first Unit Trust was introduced) if you wanted to invest, you’d have a few options: property, stocks or government bonds. Property needed to be physically held whereas stocks and bond ownership was shown through the holding of a certificate. This is once a stockbroker had physically executed your ownership on an open outcry floor. Stocks and bonds used to be traded through different exchanges. The 60/40 ‘balanced’ fund approach introduced in the 1960s with 60% in shares and 40% in bonds, is still used today. Interestingly, the first global unit trust was introduced in the UK in 1931.

When unit trusts came on the scene everyone could get stock diversity without having the critical mass that you needed to buy a share. You needed to swap your fundamental understanding of the company whose shares you were buying that you used previously for an understanding of the risk associated with the unit trust you were buying. Certainly historically ‘share concentration’ for retail investors was a real thing as retail investors were likely to hold onto a share once they had bought it. People also inherited shares (and would not touch them for sentimental reasons), or bought them when they were working for a company – all leading to suboptimal portfolios in  the long term.

Stockbroker remuneration (their fee for picking stocks) used to be at least 1%,  but no more, their fees are now closer to .5%, or they use a sliding scale, much like asset managers. (An Asset manager usually has experience in managing other asset classes than just stocks – i.e. corporate and govt bonds, REITS, Commodities, Cryptocurrency etc).  

Unit Trusts took away much of the angst around picking the right stocks or blend of assets (in other words adding in bonds,  property,  commodities etc.)  and ensured diversification. There are over 1800 Unit Trusts in South Africa and can be found on the full spectrum of assets, from highly niched, to broadly diversified.  Unit Trust asset managers used not only stock picking but also the skill of allocating assets to a wide range of asset classes (and often several asset managers, each with a different specialist had to be employed). This naturally commanded higher fees, and these started to inch up into the 2% range. At some point performance-based fees were also introduced. Once unit trusts are wrapped in a life license (or an administrator is used) to house your retirement capital this can add another 30 basis points to the cost. Another wrinkle to the fee game is for a FSP to bundle together a bunch of Unit Trusts to form yet another Unit Trust – called a FOF or Fund of Funds. This is often done by FSPs or brokers who wish to blend various single asset class unit trusts to form a separate FOF. The thinking is that asset managers excel in one asset class and using them for only this asset class but to blend their returns with other similar managers will give superior returns that can justify the extra cost associated with a FOF. There is also a practical reason for FOFs, smaller FSPs may not have the asset management knowledge to pick their own stocks or assets, but like the cachet of having a unit trust in their company’s name – and earn some more fees. (You might have guessed, I am not a fan).

It is easy to dismiss the fees as only another 1 or 2%, but bear in mind that for every R1m you have invested, that is R10-20k p.a in extra fees. Those fees are going to advertising, sponsorship, fancy head offices etc. This model of heavily advertised unit trusts (incurring more costs that have to be recouped from investors) has worked very well for asset management companies – but is bigger necessarily better? Remember that asset management companies don’t assume risk such as an insurance company where, growing the risk pool allows for an underwriting shock to theoretically be weathered better than a smaller risk pool. Larger is better.

That is not the case with a unit trust. If the market tanks, your investment tanks with it, and the asset managers just get a slightly lower fee until the market recovers. A very large unit trust, especially in a small market like we have in RSA, stands the risk of owning a large part of the free float shares in issue for a particular company. Even if a great investment opportunity reveals itself, the fund may not get the percentage allocation it wants and the contribution from such an investment may be too small for the effort involved. Then there is the tricky issue of board representation. If an asset manager owns a large quantum of shares, they may very well want a say in how the company is managed. The skill set is now not so much about just picking great investments but ensuring strategic direction at corporate level as well. Also consider that parting with a holding where you are a sizable investor poses its own set of risks. It may just not be possible to divest even if you wanted to.

Then there are the fees that go to the advisors. Of course I’m biased being an advisor myself, but you might be surprised at the number of people who see no value in an advisor or see advice as a once off exercise. These advisor fees can take numerous forms. Traditionally in investments an upfront fee/commission can be charged of around 3% – but this is not as popular as it was and may still be levied by old-school brokers. (To be fair, I do get their point that much of the advisory work is done upfront and so they should be compensated for it, but it can result in a disincentive to build a long-term relationship with ongoing advice).  The ongoing fee is usually levied as a percentage of Asset Under Management (AUM) and while it is legislated at 1.5% p.a. (before VAT) the industry average is 1% p.a. Some advisors charge an upfront fee to draw up the financial, retirement or estate plan (say R30k-R50k) and may discount the ongoing fee to 0.5%. There are advisors that charge a fixed retainer, and even some who charge by the hour in much the same way that a lawyer would (a qualified and experienced advisor charges R5000+ p/h).

There are numerous reasons you should have a financial advisor (look out for my next post where I am going to go into this in more detail) but in my experience it is not so much the increased performance that comes from choosing the right asset allocation, but it is the numerous ways we can save you from wasting/losing your wealth by understanding the regulatory environment, the economy, tax, trusts and other structures, estate law, offshore investment pitfalls and regulations and how any of these might impact on your specific set of circumstances. Think of the service you get from a specialist medical practitioner. Sure, you can use Dr Google and get a semi-accurate answer. But only a specialist will weigh up your medical history, genetics, current medical intake, blood results, scan results and any prior procedures. These they will then consider everything and ensure an appropriate treatment outcome. Just as you will require a medical practitioner ongoing to manage a chronic condition, so one needs an advisor to ensure that your capital which has been built up through a lifetime isn’t squandered.

Does this necessarily cost you more? This all depends on what you are trying to achieve. Do a fee comparison by considering your Effective Annual Cost (EAC) – these are the Asset Management fees (used to be called the TER – total expense ratio), plus platform/admin/wrapping fees and Advisory fees.
If you have more than one source of wealth, remember that by consolidating your wealth with one advisor/asset manager team can be used to drive down your overall EAC. I know that there are still the ‘all my eggs in one basket’ concern, but there are many safeguards that have been put in place since 2008 to protect the client, mostly through the use of third-party custodian banks. (Very briefly, this is when an investment FSP that holds the unit trust or investment (for example) uses a completely independent (no co-holding which is common between big FSPs and Banks) institution to be the custodian of those funds. Those funds have to be accounted for balanced daily.)

Once an advice-lead consolidated solution is implemented you may be surprised as to the fee outcome relative to what you are currently paying. A holistic financial plan is one which documents not only your financial journey but also shows how costs are going to be managed along the way. For those still in their working life, the solution may center around saving and investing to ensure that the correct quantum of assets can be accumulated. This is always a journey, as tax, capital gains, current consumption, required level of saving to achieve the end objective can rarely be effectively (or comfortably) achieved in one shot. For clients both in pre-retirement and post-retirement, this constant monitoring, skills transfer and tweaking of the plan gives the expected results without the potential huge shock that can come from a once off implementation which is then ignored for years in the mistaken belief that nothing changes.  

In short then, fees and any other costs that are associated with your investment are important to understand and determine if they are reasonable (especially w.r.t. unit trusts and FOF). When it comes to advice fee – at least be aware of the dangers of being your own Dr Google Advisor (that pond is an inch deep, a million of miles wide and filled with unknown entities with their own agendas).  

Articles and Blogs: 

The NHI and what do do about it   NEW
New-Normal for Retirement? 
Locking-In Interest rates – The inflation story
Situs – The Myths and Reality
Tax Residency – New Rules new headaches 
Are retirement annuities dead 
A new look at retirement
Offshore investing – an unpopular opinion

Cobie Legrange and Dawn Ridler, 
Rexsolom Invest, Licensed FSP 45521.