Esma found that fees included in the total expense ratio (TER) reduce gross returns of EU-domiciled funds by an average 13%. When sales and redemption fees are added, “gross returns on EU mutual fund shares are reduced by 20%”.
Fees reduce returns by 15% for retail equity funds, and 10% for institutional funds. But bond fund investors forego a much larger share of their profits, despite fees on bond funds being substantially lower. But the generally lower returns in this asset class mean the impact of fees on returns is a lot higher: investors in institutional share classes of bond funds lose 17% of their gross returns, but investors in retail funds lose an average of 32%.
Lack of fee awareness
The Financial Conduct Authority (FCA), the UK financial regulator, published a study last summer showing fund fees do not correlate with gross performance. Moreover, it found a slight negative correlation between gross returns and performance in two of the three asset classes it examined.
Esma also noted that “the impact of fees and charges on the net outcome to investors does not seem to be reflected in investor choices”.
While the FCA found that performance is uncorrelated with fees, Esma concluded that fund flows are not correlated to fees either, when corrected for performance, with the exception of retail bond funds, commodity funds and money market funds.
This conclusion is debatable, however. After all, the rise of ETFs as alternatives to active funds has a lot to do with ETF fees being lower, especially on the equity side.
Nevertheless, Esma has now received a mandate from the European Commission “to issue recurrent reports on the cost and past performance of the main categories of retail investment, insurance and pension products,” it announced on Friday.
The regulator noted that situations of low gross returns and commensurately high relative fees “are more likely to occur in the current low interest rate environment, reinforcing the vulnerability of investors to low performance by their investments in the fund industry”.
Apparently, Esma’s initial findings about the sheer loss of gross returns to fees were shocking enough for it to assess the reporting of costs and past performance of retail investment products by asset managers, “in order to increase investors’ awareness of the net return of these products, and the impact of fees and charges”.
Asset managers, brace yourself
It’s time for asset managers to brace themselves: the competition from passive solutions has been putting downward pressure on fees over the past few years, resulting in lower margins. Regulators have so far been reluctant to turn up the pressure. This was exemplified by Esma refusing to name the funds it had identified as “possible” benchmark huggers last year, and Luxembourg’s regulator claiming last summer there were no benchmark hugging funds among the 4,100 Ucits funds domiciled there.
But this new Esma initiative may very well mean the pressure on active managers will from now on come from the regulators too. As the EU embarks on its next phase of integration, it is more than keen to show to its often-sceptical citizens that it works to their benefit, and not to that of big business.
The multi-asset and unconstrained bond space are the areas that have seen most investor inflows, and have escaped competition from passive managers. They also charge fees that are typically higher than those charged for equity funds, even though returns are lower. Multi-asset funds, for example, escaped scrutiny in Esma’s initial study.
The average management fee for a ‘flexible allocation’ fund is 1.26% according to Morningstar. This compares with a management fee of 1.19% for European equity funds and 0.66% for European corporate bond funds. Gross returns for multi-asset funds, however, are closer to those of bond funds than of equity funds.
Expect Esma to pay some attention, perhaps unwanted attention in some quarters, to multi-asset fund charges over the coming months and years. After all, these are the kinds of funds most popular with the consumers the regulator has vowed to protect.