INSTITUTE OF FUNDRAISING: Investment management fees - Is what you see what you get?

Lucy Maggs

Charities looking for good value from their investment managers should not only be looking at their portfolios, but also at the fee structure.

Poor stock market performance over the past few years has meant that charities renewing their investments are anxious to ensure that they get the most out of their money. But aside from looking at investment strategies, organisations also need to make sure their returns are not being eaten away in investment management fees.

The trend in fee structures is shifting, with charities increasingly looking to performance-related fees, something previously reserved for pension funds and other large institutional investors. The advantage of this system is that clients can keep the heat on fund managers - if their investment portfolio is suffering, then so is the fund manager.

But some investors worry that performance-related fees push fund managers to take extra risks, not always a popular strategy with charities, which tend to be cautious investors. David Kidd, deputy managing director of investment managers, Chiswell Associates, says that performance-related fees can lead to what he refers to as the moral hazard problem. "If a fund is performing just below the benchmark, having a performance-related fee structure might encourage the fund manager to take bigger risks."

Fees tend not to be entirely dependent on performance; instead managers usually have a set fee with a performance-related element built on. For example, many investment houses will have a set fee they receive if they beat the agreed benchmark by a certain percentage. If they don't achieve this, they will be paid less; if they beat it they will be paid more, although fees will be capped at a certain point.

The problem with performance-related fees is their unpredictability.

Small and medium-sized charities are likely to want to know exactly how much they are going to have to pay and when. Nick Rickard, head of investment services at the Charities Aid Foundation says: "Performance-related fees will tend to suit larger charities. For smaller charities with less disposable income, budgets are tighter and charities need to know what's being paid out when."

The most common fee structure is known as 'clean fees'. This means that the investment house rolls all the fees into one straight charge. These include all the investment management charges, custodian charges (where clients are charged for investments to be held in the name of a custodian) and cash management charges.

"The appeal of clean fees is that charities know from the offset exactly how much they will be paying," Kidd says. "There is a strong desire on the part of clients for transparency. This means the client just pays the fee and nothing else."

Hidden costs

However, Kidd adds, this has been subject to abuse in the past. Charles Mesquita, head of charities at Carr Sheppards Crosthwaite, agrees: "Trustees must watch out for hidden costs," he warns.

Charities embarking on a contract with supposedly clean fees must be aware that they are not always so straightforward - many fund managers will add some costs on top of set fees. Predicting the costs of third-party transactions, for example if a stockbroker is needed for trading, can be difficult and some managers have found it more efficient to keep this kind of charge separate from the fee.

Chiswell has elected to take this route. Kidd says: "If we are charged 0.2 per cent commission by a broker, for example, we will pass this cost on."

The significant advantage here in paying commission is that there is no VAT payable - which there is if fees are paid. Some investment houses will help clients avoid VAT by charging commission during the year and then deducting the total amount paid from the fee at the end of the year.

Moving away from clean fees, some investment houses will add additional commission to the costs of various transactions such as dealing with third parties and custodians. This means fees will be considerably lower, and there are VAT advantages. But this could provide managers with an incentive for unnecessary transactions - although most scrupulous investment houses will protest that this would not be allowed to happen.

Sliding fee scale

Fees will also tend to vary according to the amount of money invested.

Most investment houses have a sliding scale, weighted in favour of larger charities with more money to invest. David Bailey, vice president of charities at Deutsche Bank says: "The more money you have, the more clout you have for negotiating fees." The make-up of the portfolio will also affect fees, with some investment styles needing more management time. An ethically constrained portfolio, for example, would bring about higher fees.

Asset classes will also affect investment fees. A property fund for example is likely to have fairly high fees as it will need a dedicated, specialised team, and hedge funds, because of their riskier nature, often have performance-related fees.

Because there are a number of ways charities can pay investment management fees, trustees need to take into consideration the size of their investments, investment style and asset allocation in order to ensure they are getting best value.

CAF's Rickard says: "What's most important is value for money." He argues that one of the main problems among charities is they do not review their investment managers often enough. "Charities need to do regular reviews of their investment portfolios every three to five years, which will enable them to see not only which managers are performing well, but also what the different fee structures are."

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