Cost-effective investment strategies provide guaranteed advisor alpha

The issue of costs is not only highly sensitive, but potentially very confusing for investors too. Advisors can create an understanding of how investment costs are structured as well as help clients reduce these costs through appropriate product choice and portfolio structure. Even a small percentage cost-reduction can make a big difference to a client’s long-term investment growth. 

Successfully implementing a cost-effective investment strategy boils down to simple maths. The lower the
investment costs, including investment management charges, advisor charges, administration charges and other charges, the higher the potential net return for the client. This logic applies regardless of market performance. It therefore follows that future net returns of an investment are guaranteed to be higher than if the same investment was subject to a lower fee.

Consider all the relevant fees that impact your client
This involves a detailed study of the breakdown of the effective annual costs (EAC), where each component of charges in isolation offers an advisor the opportunity to reduce costs for the client. The graph belowillustrates the typical costs for an investor, an advised client whose investments sit in a portfolio of multi-asset funds. 

 Investment management charges

For collective investment schemes, fund costs are disclosed as total investment charges (TIC) in a fund’s Minimum Disclosure Document. Investment management charges include the product fee (or asset management fee); transaction costs; underlying TERs (if other funds are used); audit and trustee charges. The table below illustrates the make-up of the TIC.

 Investment management charges generally make up the largest proportion of the EAC. To help lower fees, and thus increase the chance of outperformance, financial advisors across the world are increasingly using passive alternatives as a portfolio core and incorporating active funds around these low cost solutions. The advantage of this strategy is that the portfolio incurs lower fees, while retaining the potential of generating alpha over a representative benchmark. The chart below illustrates how the introduction of a passive element to a portfolio helps to reduce the investment charges.

 In this example, a typical portfolio with no allocation to core investment funds would start off with an annual fee of 1.43%. However, as the allocation to passive investments increases and works together with the allocation to active investment funds, the annual fee decreases. 

The bottom line is that clients who are paying lower fees keep more of their investment for themselves than clients who are paying higher fees. This applies whether the markets are performing well or if they are in a downturn, which makes cost-effective investing a key component of an Advisor’s Alpha.

In addition, as the Nedgroup Investments Core Range has demonstrated¹, the inclusion of a low-cost passive solution does not necessarily come at the expense of performance.

Advice charges
The initial and ongoing charges an advisor can charge a client are defined in the FAIS Act. When it comes to advice charges, fostering a strong relationship with the client and becoming a trusted behavioural coach for a client is a key value-add. This becomes particularly valuable in volatile markets or during times of underperformance as it is during these times when a client with a trusted advisor can draw on the advice they receive to remain disciplined in their financial behaviour. Showing material value-add from advice charges is a challenge but advisors who check-in regularly with their client and consistently evaluate the performance of a client’s portfolio will be adding significant value by gaining the trust of their clients and being able to guide their financial decisions in a responsible manner.

Administration charge
Financial advisors sometimes use Linked Investment Service Provider (LISP) platforms for one-stop access to a wide range of financial products from various providers. This allows them to easily structure portfolios in ways that provide clients with optimal long-term solutions through a single channel. The benefit to an investor is that product fees tend to be cheaper than if one accesses the same products directly from the management companies. However, LISPs also charge an administration fee that must be taken into account. By helping clients access LISPs with cheaper platform fees or negotiate lower LISP fees on their existing platforms, advisors can help reduce overall costs for investors.

Other charges
This is a catch-all line item that would include wrapper fees, guarantee charges, smoothing benefit fees, penalties for termination or early redemption and any other applicable charges that aren’t listed in the other sections. The financial advisor’s value with regard to these charges is to encourage product choices that do not have onerous layers of fees or aren’t appropriate for a client’s goals. 

By eliminating other charges, it is possible that a client’s EAC be reduced to lower than 3% p.a. With advice charges bearing a closer resemblance to international ‘best practice’ (0.969% p.a.), carefully selecting a LISP platform (0.456% p.a.) and using a passive allocation of 40% (1.043% p.a.), the conservative total alpha that could be added is 0.67% p.a. (This translates to an EAC figure of 2.47% p.a. against the 3.14% p.a. starting point presented above.)

As costs are a source of large detractions in investment returns, the additional alpha an advisor can generate for clients from this cost exercise is a guaranteed value-add that is not dependant on market performance.

Nedgroup Investments has launched an Effective Annual Cost calculator that is available at nedgroupinvestments.com which offers investors and financial planners a more transparent approach to cost disclosure.

¹See Jannie Leach’s article in this issue titled: ‘Dispelling the myth around low-cost investing’.