Brent Sheather: Return-free risk

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This column has long argued that the cost of investing via managed funds through intermediaries is far too high, relative to returns, with the net result that Mum and Dad buying into the standard financial planning investment proposition are frequently left with return free risk, i.e. after fees, the risk of equities with a return approximating that of bank deposits.

But, more often than not, these accusations have been generalised rather than specific.

The last time we looked at the actual cost of doing business with a financial adviser was in October 2011 in the report "Use Common Sense to Assess Financial Plans" where we analysed an investment plan prepared by a private bank.

Despite the new code of professional conduct for Authorised Financial Advisers, which says "you have to place a client's interests first" we estimated that the financial plan would see more than one third of the client's prospective returns going to the adviser/fund manager rather than the client. If that wasn't bad enough fees would take almost 50 per cent of the cash income produced by the portfolio.

Back in 2004 another Herald story looked at the actual costs of a selection of popular mastertrusts. We found that all up costs for a balanced portfolio totalled an eye watering 3.0 per cent pa. There is more significance to the 3 per cent than meets the eye many current estimates of the risk premium of equities over bonds are in the range of 3-4 per cent.

This week's story updates this work. It is difficult to get cost information and, unsurprisingly, most advisors are reluctant to give too much away however we managed to get the actual fees charged by one of the larger players in the industry no names because it isn't fair just to single out some providers and this writer doesn't need the aggravation. The good news is that fees are down a little but the bad news is far more significant and it is that prospective returns have collapsed with a capital C.

So let's get stuck in and see what is on offer for Mum and Dad, retired with $250,000 to invest, from the NZ financial advisory market, by looking at prospective returns and then deducting annual fees.

First under the microscope are fees. The firm in question uses a mastertrust platform which undertakes the management of each client's account and permits investors to access a range of investment products through one investment door. Many NZ firms use mastertrusts as this provides most of the infrastructure they need to do their job without them having to actually buy the infrastructure. In effect they lease the infrastructure and the client pays for it.

Great business model! Although the spin says mastertrusts make the admin of your portfolio cheaper and simpler a closer look suggests that the fee structures are far too high. Mastertrusts were conceived some 20 years ago at a time when all the stars were aligned for financial markets.

However their cost structures in today's low-inflation, low-return, environment are much too high. The master trust in question had total management and administration costs of 1.8 per cent so if you assume turnover costs of 0.5 per cent pa that brings total annual expenses excluding monitoring fees payable to the adviser to 2.3 per cent pa. Monitoring fees were quoted at 1.0 per cent to give total annual expenses of 3.3 per cent.

This is a big number and it doesn't include the cost of actually initiating the investment. To determine how significant these fees are we need to make a judgment about returns. A few years ago one "Fund Manager of the Year" declared that costs were irrelevant, it was performance that mattered. Of course, his view was quite ridiculous - various studies in the US and the UK show that a managed fund's after fee performance is inversely proportional to fees.

Funnily enough, common sense comes to the same conclusion. But to put these costs into proper perspective we need to know what sort of return is likely from a balanced portfolio in the next 20 years. If we can expect 15 per cent a year from shares and 5 per cent from the bank who cares if fees are 3 per cent or even 4 per cent?

Alas, 15 per cent from shares is unlikely short term and impossible long term. Economics says that returns from shares will be equal to the dividend plus the growth rate, i.e. for international shares today the prospective return is 2 per cent to 3 per cent plus 4 per cent = 6-7 per cent. This is the same conclusion a meeting of experts in the US came to earlier this year which we covered see Herald article 25 February 2012 "Leave Market Forecasts To The Badgers".

Further evidence of low prospective returns comes from the leading regulatory body of the banking and financial services sector in the UK, the FSA, who recently updated a discussion paper on what is acceptable practice as regards projections of future returns by the financial services industry.

The FSA commissioned PriceWaterhouseCoopers (PWC) to come up with the numbers and they forecast long-term nominal returns from a diversified portfolio of just 5.0 per cent per year. PWC also cautioned that there was considerable downside risk from this forecast. That is not difficult to understand when you look at bond yields.

Assuming a portfolio is 50 per cent in bonds yielding 3 per cent and 50 per cent in shares with a prospective return of 6 per cent, that is gives a blended return of just 4.5 per cent. If we use the FSA's figures plus an extra 1.0 per cent for good measure, we get a pre-tax, pre-fee return from a balanced portfolio of around 5.5 per cent.

So there you go - if your average financial planning firm is stinging you for 3 per cent a year that's well over half of your return gone. The financial planning industry is not providing value for money the standard investment proposition offers investors the return of bank deposits with the risk of shares.

Not compelling is it! Unfortunately things don't look likely to improve in the short term as many advisors are still in denial. Just last week a highly qualified and educated AFA wrote in a newspaper saying that actuaries expect "8 per cent returns before tax and fees". This is correct, or rather it was, back in about 1990. LOL.