Asset managers have engaged in a race to the bottom in recent years, with providers competing to offer increasingly low fees, explains Fadi Zaher, Head of Product Specialist: Index, Asset Allocation & Factor Based Investing, Legal & General Investment Management. But what is the true cost?
The concept of ‘zero’ is age-old — it can be traced back to the Babylonians and the Ancient Greeks, who debated how ‘nothing’ could simultaneously be ‘something’.
Humans often make decisions in relative terms, by focusing on the advantage of one thing over another. But most people like getting something for ‘free’. In fact, it triggers an emotional, almost irrational excitement. The concept is embedded in our day-to-day lives, including;
- 'Buy one, get one free' promitions in the supermarket – two items for the price of one
- We are more likely to go to a museum when it is free despite the overcrowding and queuing, instead of being a paying visitor who saves time
- An individual’s decision to buy one car brand instead of another may be impacted by the services that are ‘included’ with the purchase, such as free repairs for the next three years
When it comes to money, how we react to ‘free’ is less clear – and even less so in the fund management industry. How we process information and make decisions can get lost in the intricacies of financial product jargon, especially where fees are baked into the price. For example:
- Foreign exchange – it is not uncommon to exchange travel money for a holiday with 'zero commission'. Yet the exchange rate for converting the cash in your wallet to another currency can be absurdly high
- Structured products – the price to purchase these could be higher than the selling price
- Zero-fee mortgages (where you pay through an administration fee). Although these may look attractive to many, the real total cost may exceed that of the non-zero-fee product
In an asset management context, if you are offered a zero fee for someone to look after your money, it is a no brainer, right? However, we often fall into the trap of buying something we may not really want due to the perception of it being ‘free’.
Management costs have been falling for several years. Many index managers are able to charge low or no fees on the back of associated activities such as securities lending or the indirect investment of their fund’s assets into other funds that are not zero-cost – even though the annual management charge of their fund is zero.
Securities lending involves the owner of an asset temporarily passing the title of the asset to a borrower in return for a fee, backed by collateral. It can aid greater market liquidity and allows a fund manager the opportunity to earn additional return. For an index manager, securities lending can be quite appealing. An index fund is unlikely to sell a stock unless it is falling out of the index. This means the fund can lend those shares to someone – for a fee – and enhance returns. However, there are risks involved in the process, requiring some scrutiny by investors to see what is under the hood.
Understanding the answer to questions about the factors that facilitate zero-cost has implications not only on the product choice, but for some of the biggest issues facing an investor: explicit costs, implicit costs and the effectiveness of the investment strategy.
The ‘free’ concept makes us feel good — and forget the potential downside. Because we think we are starting at zero, anything we get feels like a bonus. By contrast, we may feel the loss of a high-quality but expensive service. However, “there is always a third possibility, as long as you have the ability to find it” – as Swedish author Selma Lagerlöf once said. The answer to this is finding something which is ‘good value for money’. Often, that means an upfront, transparent price tag. The bottom line is that not even ‘zero’ works for nothing!
This article has first been published on futureworldblog.lgim.com.