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Prudent Investor Update, March 21, 2018

Investing 411 - Understanding Costs & Compensation

No such thing as a free lunch: Understanding and managing the costs of investing

Everyone knows that investing involves costs and fees – whether you’re an individual buying retail, or an institutional investor like a municipal government.

Broader investment options will soon be available to municipalities under the prudent investor standard. Understanding fees and managing these costs will be more important than ever - though also relevant to those who stay with the prescribed list. Brokers may try to sell products that boast “no fees” – but there are always costs involved in operating an investment product and so there are always fees.

Brian Holland, Senior Vice President at Guardian Capital LP, provides investment management services to the ONE Investment program. He explained that mutual funds, as well as other investment products, incur many operating fees and management expenses that are ultimately borne by investors, including:
  • Compensating the investment team that guides the portfolio and make buy/sell decisions.
  • Custodial charges to the financial institution that holds the money in trust. As well, there are costs associated with unitholder recordkeeping, which keeps track of who owns what units on a daily basis.
  • Costs for annual audits and legal fees for filing the annual prospectus.  An Independent Review Committee overseas the operations of the mutual fund.
  • Fees /commissions paid to financial planners and others who sell the product to the investor. This makes up a large portion of costs to the investors.
All these costs are charged directly to the mutual fund. Since they are largely predictable, the total cost is amortized on a daily basis. The total costs and fees are known as the management expense ratio or MER. In Canada, Morningstar has pegged the average MER for a mutual fund at about 2.4%.

Typically, it has been hard to find these fees. Investors had to go through the prospectus in detail and different funds used different terms. New regulations, which came into effect this year, are supposed to improve transparency on these fees for retail investors. (See the recent Globe and Mail article: New investment statement still won't expose billions of dollars in fees for more background)

While all investors want to maximize returns and reduce the costs, municipal finance staff have the added pressure of Council and public scrutiny. It’s important to understand that no product comes without a cost. But there are strategies to reduce them.

The ONE Investment Program uses the services of Guardian Capital to manage its Equity Portfolio, with fees of just 0.6%. Two of the reasons that ONE can keep expenses substantially lower than others it that it does not pay a sales commission, nor does it operate in an environment where it must serve shareholders seeking profit. Because ONE joins the assets of many investors together, it can achieve economies of scale when it comes to covering other costs, like investment management expertise, auditing and legal costs.

In short, the compounding effect of fees can be huge. It is wise therefore to pay close attention to these costs.

Aligning Compensation with Municipal Goals

Some municipal governments might be considering if they need to hire professional investment services, particularly if they are considering investing under the prudent investor standard.

The investment industry is complex, with a range of professionals available offering different kinds of service. A key consideration is how to make sure that an investment professional is putting municipal interests first.

An earlier newsletter reviewed how to manage potential conflicts of interest when using the services of an investment professional. Besides conflicts, it’s also important that the compensation of financial professionals is aligned with the municipality’s goals as the client.

Portfolio managers are generally compensated based on the size of the portfolio. But there are ways to ensure that it is more than just a flat percentage. Institutional investors such as municipalities are eligible for volume discounts.  So, expect percentage rates to decline as the amount of money entrusted to a portfolio manager goes up.  It is common for management fees to be set at an annual rate of X% for the first $10 million in the account, and 85% of X for the next $15 million, etc.  

A municipality may also be able to negotiate compensation that reflects the performance of the portfolio i.e. whether money was lost or made. For example, if the municipality’s investment account has declined in value over a certain period, fees paid to the portfolio manager could be reduced. This could hold even if the decline in value of the investment account is still better than the overall market performance.

Similarly, if the investment account has increased in value, the portfolio manager could be paid a performance bonus. There is increasing openness in the industry to negotiate these types of arrangements, and if a portfolio manager refuses to even entertain them, the municipality may wish to “continue shopping.”

Benchmarking is another key concept in investment management. Portfolio managers measure the performance of their client’s account by comparing it to the returns from a market index. Municipalities need to select the appropriate benchmark for their investments to help them to understand the value the portfolio manager is providing. Also, over time, the municipality itself can expect that Council and other stakeholders will want to know how its investments are faring when compared with its peer group.  For example, large pension funds benchmark their performance against comparable pension funds. Eventually there may be enough municipal investors to benchmark within the sector, but that is expected to take some time.