DFM and hidden charges
29 November 2016
Let’s not kid ourselves, the financial services industry has a rather sketchy past when it comes to high and hidden charges. High commissions, double charging on funds, reciprocal commissions, zero paying interest savings accounts that maintain that rate for years. The list goes on. I for one cannot believe that I relied on fund annual management charges (AMCs) for so long, as they were never anywhere near the true cost to the client.
It is now fair to say that the Retail Distribution Review has put paid to many of the shadier practices which usually had the payment of commissions at their heart. The Treating Customers Fairly initiative, together with strong regulatory supervision, has led to a relatively transparent market.
So, these days, perhaps ‘hidden charges’ is the wrong phrase to use. In the discretionary world, where there is no real standard disclosure format, it is probably more accurate to say that some charges are harder to find. Unless you know where to look and what questions to ask, it would be easy to leave out a charge from any analysis.
Not only is it unfair to clients to be hit with unexpected charges, it can put advisers in a bit of a regulatory pickle, especially when dealing with transition of assets from one solution to another. There are many elements that can lead to a recommendation of asset transition. Some quantitative and some qualitative. In the end this is a value for money judgement which requires an accurate assessment of total cost.
Defaqto can testify to the difficulty in identifying all relevant and significant charges in a discretionary management service. There is no standardised methodology for calculating cost, as there is with funds. Defaqto Engage carries the equivalent of ongoing charge figures (OCFs) for some 800 plus managed portfolio service portfolios which will obviously help advisers in their decision making.
The areas where we find we have to be particularly vigilant are around estimates of transaction fees, where charged, coupled with estimates of portfolio turnover rate (one is not much use without the other). And of course, for those portfolios available through platforms, the platform fee and indeed other administration fees will vary from platform to platform.
With bespoke services, the difficulties increase further in that charges levied can also be bespoke to the client and the elements and frequency of charges will depend on the mandate agreed with the individual client and, for instance, whether or not this means a more actively managed portfolio or whether cheaper passive funds are used.
So, let us take a closer look at some of the potential pitfalls.
Let us assume that in all respects, other than cost, two solutions (current and potential alternative) appear the same. However, the current solution appears 0.25% per annum more expensive than the new solution being considered. There is certainly justification here for transitioning the assets in to the new solution on the grounds of cost. However, the adviser will have to be absolutely certain that they have taken all significant charges in to account. Comparing headline rates for a service just will not cut it.
The assessment of cost can be a research minefield. One way to go about it is as follows:
Firstly, consider who needs to get paid:
- The adviser
- The discretionary portfolio manager and the research teams
- The broker who undertakes the trading
- The custodian/administrator
- Accountants and possibly other third party outsourcees
- Managers of any underlying funds (could be internally run or by a third party)
- Even in some cases funds in underlying fund of funds
- Adviser platform
This will get you started on where to look.
Then, it is worthwhile thinking about the different structures:
- All in headline service fee (bundled) – would tend to include any transaction fees, but not necessarily all others
- Unbundled fees where all elements of the service are charged for separately
- Services where the higher the investment/value the lower the service fee gets (in percentage terms)
Looking at the above will get you thinking about which services have variable charges, depending on the client wealth and also which services are likely to have an extended list of potential individual charges.
It should be noted that there are a few services that quote a service fee of zero. This is a little misleading as no-one is going to run a discretionary service for free. These particular services are structured using internally run funds, and part of the annual fee for these funds will go towards running the discretionary fund management (DFM) service.
A true hidden charge I hear you shout. Not necessarily. A discretionary management service fee is subject to VAT. Annual fee on a fund is not, so there is a potential tax saving to be had with this structure.
So, where are all the potential pricing points. Let’s break this up in to three sections: upfront, ongoing and exit:
There are only one or two discretionary solutions that we are aware of that still charge any sort of up-front fee (but check anyway). However, beware of:
- Upfront fees on any underlying funds, particularly in house funds
- Investing through a platform, check to see if the platform charges an upfront fee
- The platform policy on transaction fees (this applies to ongoing as well). Some may be included in the platform fee, some may charge a single transaction fee that is split between all clients, whereas others will charge a full transaction fee per client
- Those services operating an unbundled service charge initial transaction fees
- Transaction fees for the purchase/sale of funds such as unit trusts and open ended investment companies (OEICs) – there should be none. This is not necessarily the case for funds/trusts dealt on the stock exchange eg exchange traded funds (ETFs) and Investment Trusts
- There is the annual fee for the service itself. Do not be put off by the headline rate, as many DFMs are open to negotiation dependent on likely assets committed. It is a competitive world out there
- Don’t forget that some services drop their rates as clients assets reach certain thresholds
- Where transaction charges are explicit and charged separately, it would be useful to have some idea of the portfolio turnover rate. Also ask what the transaction charges are, as they can vary considerably. In percentage terms, the lower the value of the portfolio the bigger the drag on returns
- For unbundled structures, there can be a long list of individual administration charges which, in addition to transaction charges, may include:
- Custodian fee
- Ad hoc valuation fee
- Cash transfer fee
- Dividend collection fees
- Shareholder vote/corporate action fees
- Probate valuation fees
Many individual charges can be found in the terms and conditions, but it is important to ask what else can be individually charged. Individually, the above may not add up to anything significant, but it is important to check.
If investing through a platform, do not forget the annual platform fee. This can be looked upon as the custodian fee. The annual fee from the discretionary manager, generally, should be commensurately lower as most administration, custody and service is provided by the platform.
- Possible application of transaction fees that have not applied up to this point
- Check charges for any in-specie transfers out of the service. Perhaps not unreasonable to make a small administration charge here
- If applicable, check the platforms policy on exit charges. There may actually be cost, and certainly administration, savings to be had if moving from one service to another on the same platform
Although not an explicit charge, it is worth mentioning interest on client cash . Less than half of the solutions that we cover pay any interest on client cash. If holding cash as an asset is subject to annual fees, the same as more ‘active’ assets, then it is reasonable to expect some payment of interest. If not, then perhaps with interest rates currently this low, zero interest may still be a good deal, as fees are likely to be higher than any potential interest return. But remember, interest rates will rise at some point.
The charges and structures mentioned here are unlikely to be an exhaustive list, but hopefully this article will put you in the right frame of mind to consider all possibilities. Charges no longer tend to be hidden, it can just be a very long list, and as such difficult to come to a true cost.