The Investment Association is finally tackling the issue of disclosing portfolio churn but the road to full transparency is going to be long and fraught, finds Stephanie Baxter.
Hidden charges such as transaction costs can have a material impact on a pension scheme's returns, particularly when assets are actively managed. Beyond the headline fees that asset managers charge, the impact of transaction costs on portfolios is still extremely opaque in this country.
The Investment Association, formerly the Investment Management Association, has been applauded for tackling the issue in depth in its mammoth paper, Meaningful Disclosure of Costs and Charges.
The paper calls for further work on calculating transaction costs through the portfolio turnover rate (PTR), which the trade body has previously called an inaccurate measure that should not be reported. The higher the PTR, the higher the transaction costs, which can include commission, bid/offer spread and market impact.
Pensions Institute director David Blake, whose damning research last year revealed that hidden costs accounted for up to 85% of transaction fees, says he is "quite encouraged" by the association's change of attitude. The body was criticised at the time for not going far enough to give full transparency on costs, despite proposing a new accounting standard for fund costs in pounds and pence.
Blake says the impact of high level turnover on reducing returns had previously not been recognised. "All active managers reported was their apparently superior performance, without recognising the cost that resulted from lots of trading in the portfolio. At least now we will get some material attempts to find out what the costs are and measure them."
This is particularly important in defined contribution funds where the regulator and government are working on improving disclosure of transaction costs, which are not included in the 0.75% charge cap that applies from April. The work of European policymakers in improving cost and charge transparency will shape this.
KAS Bank managing director Chris Sier says a lot of defined benefit (DB) pension schemes would be surprised to see the amount they are paying in transaction costs. "If you are a pension fund with a high equity component, then yes you will be shocked," he says.
A few years ago before joining the Dutch bank, Sier worked in a research capacity to find out how much the Local Government Pension Scheme was paying in fund management fees. By analysing data on the scheme he discovered equity turnover was over 100% across the funds, significantly more than claims by some managers that their turnover is only around 20%-30%.
This means the portfolio is being turned over once a year, which can add to significant hidden costs. Sier found that a portfolio turning over once a year incurs on average 15 basis points (bps) for full service, research and execution costs in addition to 50 bps in stamp duty. This amounts to 65 bps, even before including implicit costs of trading such as bid/offer spread, market impact or implementation shortfall. If turnover is above 100%, costs will be even higher.
Shaking the asset managers
Lifting the lid on transaction costs will shake up the fund management industry.
Blake says: "We live in an industry where active fund managers are saying they're good and can beat the market, but I know from my own research this is not true and there are only a very few star managers. The average fund manager does not beat the market after you take into account transaction costs.
"They've really got to record this information because they're carrying on turning over the funds, incurring charges, with no net benefit to most investors."
There is a now a debate to be had over how to calculate these costs. There have been doubts over whether asset managers have the sophisticated technology to gather this data, but Blake believes modern platforms that firms already use for recordkeeping are sufficient. The Investment Association's paper says there are a number of commercial services that can assess quality and that one of its members uses a third party to take data on all trades.
Getting to full and consistent disclosure on all charges and costs is going to be an "extremely complicated" journey, says Sier. He does not think that starting off with the single ongoing charges figure is the way to do it and says what is needed is analysis and proof. He adds: "We should collect some basic data and take it from there. I sadly see it as a delaying tactic to go to the pounds and pence measure when actually there's a whole lot of data to collect to get us to the end journey."
After collecting the data and measuring it, the next big challenge will be how to present it in a way that trustees and independent governance committees can understand. The paper says managers should include in their annual report a narrative disclosure and discussion of transaction costs incurred with regard to the portfolio turnover rate. The association's public policy director Jonathan Lipkin says PTR numbers on their own can be quite misleading and that written or graphic narrative would be necessary to put the data in context.
National Association of Pension Funds (NAPF) interim investment affairs expert Iain Cowell warns that, while improving cost and charge disclosure gives trustees a further tool, it "can't exist in isolation and become a driver for decision making."
Sier believes trustee education and independent analysis will be crucial for trustees to make use of data to judge whether they are getting value for money.
The Investment Association's paper is a step in the right direction on the long journey to full transparency. Collaboration between all interested parties as well as academics, regulators and policymakers is essential.
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