New regulation increasing cost transparency is only the first step to lower costs
The hottest topics now in institutional asset management are ones that were barely on the agenda until the 2008 financial crisis, but still remain incompletely addressed: transparency and costs.
Both investors and regulators drive the debate. The European Commission recently introduced new regulation to ensure transparency; both the Markets in Financial Instruments Directive II and packaged retail investment and insurance-based products target increased transparency by obliging the asset management industry to disclose all sorts of detailed cost elements. Even if PRIIPS does not affect disclosure to institutional investors, it still will have an effect in increasing overall transparency for all market participants.
In June, the U.K.'s Financial Conduct Authority published its asset management market study, comprehensively listing the shortcomings of the industry and pondering the introduction of cost limits. The FCA stated the obvious: High costs do not indicate superior quality and do not generate a better performance. Conversely, high costs have a negative impact and worsen performance.
The Irish Central Bank echoed this in its own analysis, citing a lack of transparency and fees that, in many cases, were too high. This was a surprise to many, as only Luxembourg is a larger hub than Ireland for asset managers in Europe, and historically Ireland has welcomed asset managers with little scrutiny. The ICB went as far as asking for Europe-wide scrutiny into asset management costs and fees by European Securities and Markets Authority.
All of these initiatives will force the asset management industry to become more transparent about costs.
The most important question, and one that troubles institutional investors the most, is: Once transparency is achieved, how can investors actually reduce costs?
Two crucial elements are:
- Determining target costs: i.e., what does an optimal cost structure look like?
- Implementing: how to move from quantifying the gap, to closing the gap and ultimately improving net performance?
Look at whole picture
Total cost involves much more than explicit costs such as management and performance fees; other costs and process efficiencies have to be considered.
Operating large composites creates significant scale and high profitability for the manager. Yet, large composites lead to high implicit transaction costs and lower performance for investors.
Therefore, is it justified that a manager running a large composite charges the same management fee as a competing manager who runs a significantly smaller composite and has significantly lower transaction costs? Probably not, if your perspective is total costs.
In order to understand all other cost elements — in total often higher than the management fee — these costs must be measured meticulously and the relevant processes analyzed. The costs are as diverse as hedging, implicit or explicit transaction costs, custodian and administrator charges, securities lending revenue and the split of revenue between client and manager, costs of collateral management and what managers label as "other costs" in private market investments.
In total, for a large portfolio with exposure to all asset classes, there are more than 100 relevant cost elements and processes.
To measure and understand total costs is complex and time consuming. Even cleaning raw transaction data often costs many man-days of highly skilled professional labor. After measuring, costs and processes have to be mapped against a comprehensive set of peer data in order to identify cost drivers, determine target costs, identify appropriate measures to close the gap and implement best practices across the value chain.
Transparency is imperative
Regarding management fees, the lack of transparency regarding competitive fee levels is a significant challenge. Many asset managers ensure investors are not allowed to disclose their fee arrangements. The motive is clear: price-setting power diminishes when the market knows what the lowest paid price is for a certain service.
Investors hope to get a better deal (typically on very little actual evidence) by agreeing to non-disclosure, but risk overpaying. This contributes to opaque markets and imperfect competition. Those less well-informed will be charged more by managers.
All of the databases and fee surveys available publicly, or by subscription, rely solely on asset managers sharing their standard fee schedules. Those fees are 10% to 60% higher than what investors actually pay after price negotiations. This means any institutional investor, benchmarked against these numbers, is getting a good deal.
However, investors might actually be overpaying even if the deal looks good on paper. Non-disclosure obligations about fee arrangements and limited availability of information make it very difficult to actually find out. For competition to truly thrive in the asset management market, more transparency about paid prices is imperative.
Once target costs are set holistically, the next step is to develop an action plan to actually close the gap. This requires detailed and in-depth knowledge of the entire value chain of institutional asset management.
Boards of trustees need effective ways to understand and quantify costs. Broad cost comparisons with other pension funds do not help, as they neither identify cost elements that potentially can be optimized or put cost in the context of each single manager's performance.
Once trustees are enabled to understand how cost efficient each single manager is, costs can then be challenged and management tasked with finding ways to optimize them. Ultimately, high-cost managers must only be tolerated if they generate significant and consistent risk-adjusted outperformance, outweighing the inefficient cost structure.
This could be a simple and effective contribution of investors to more competition and lower costs in institutional asset management.
As reduced costs are the safest return, investors are right to make the topic a priority.
Wolfram Klingler is managing partner at XTP AG, Pfaffikon, Switzerland. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.