Investors have been far too focused on low fees over the last three years, argues Blue Sky Alternative Investments chief investment officer Alex McNab.
Industry super funds are marketing low fees as the ‘be all and end all’, and the Financial System Inquiry is keeping that momentum going, pushing for lower fees on superannuation.
It seems big super funds in Australia prefer to underperform as long as their management expense ratio (MER) is low – as opposed to paying a higher fee and making money.
The hunt for ‘low fees at all costs’ is hindering returns to end investors.
While fees are an important contributor to overall portfolio returns (which should be the objective for most investors, after all), low fees are just one element in the long-term performance of a super account.
Rather than focusing on the average fees they pay across the entire portfolio, investors can achieve better results through a mix of high and low fee structures.
The lion’s share of a portfolio should look at low fee options (ie. an index fund or a low-cost beta fund) and a small chunk of a portfolio should chase alpha and pay higher fees (such as actively managed alternative investments) to bring best results.
Getting what you pay for
Most Australian portfolios have exposure to the listed equities market.
History and academic evidence suggest it is hard to outperform in the equities space, which means the difference between a high-performing manager (that charges high fees) and a low-performing manager (presumably charging low fees) when it comes to equity is modest at most.
In this context, most equity managers end up looking like the index return – or a little bit worse, once you take their fees into account.
In this context, it rarely makes sense to pay active management fees for listed equities exposure.
If all you are getting is market returns you might as well get it cheaply.
There is no point paying a high fee for a modest performance and modest returns.
The part of the portfolio that is generating beta should be built with low-cost, low-fee options (such as an index fund or a smart beta fund).
Many investors aspire to do better than market returns, looking for a bit of outperformance.
Again, history would suggest that the best way to do this is not to look for a better Australian equities fund manager, but to allocate a part of their portfolio to different asset classes that can provide uncorrelated, outperforming return streams.
These asset classes include hedge funds, private equity and venture capital, private real estate and real assets, all falling within the category of alternative investing.
But with an alpha strategy, the dynamic changes: picking a good manager is much more important.
The difference between good managers and poor managers is wider, and these differences tend to persist over time.
Weighing up the alternatives
Allocating to alternatives will mean a higher fee (because alternative strategies are more expensive to implement), but in general a high performing investment manager will earn the fee – they will deliver performance that is genuinely differentiated.
The most sophisticated investors around the world know that it is worth spending money on that part of the portfolio for extra returns.
US universities endowments, like Harvard and Yale, have allocated more than 50 per cent of their portfolios to alternative strategies, which has contributed to them outperforming the market over very long periods of time.
The Future Fund in Australia also has a substantial allocation to alternative assets.
Traditionally, access to these alternative strategies has been restricted to institutions and very wealthy individuals, but that is changing with the emergence of new products that can give smaller investors (and their self-managed super funds) exposure to the uncorrelated return streams provided by alternatives.
The industry needs to stop seeing fees as the be all and end all.
By focusing on overall fees, investors risk paying too much for some exposures (beta), not enough for others (alpha) and not allocating enough to the asset classes that can deliver real outperformance.
This seems like a pathway to mediocrity.
Alex McNab is the chief investment officer of Blue Sky Alternative Investments.