Jul. 14, 2009
In the third part of our series we focus on the hidden costs clients of wealth managers have to pay. By understanding their significance and structure, clients have big additional lever to cut their costs of wealth management.
Because no matter what pricing model you choose, they have all one thing in common: You only see the direct costs such as transactions costs, flat- or performance-fees. What you do not see, but pay as well, are the hidden fees and costs for the various investment products in your portfolio. These costs are called “hidden”, because most of the times neither the banks nor the wealth managers communicate them clearly to the client.
It is not only products that have hidden costs. On the transaction level, various hidden costs can occur too. The most obvious method to generate additional costs in a transaction-fee model is the execution of unnecessary transactions. But even in an “all-in-fee” model transactions can cost additional money. For instance, this may happen by calculating buying or selling prices in a manner unfavorable to the client.
The various hidden costs can easily add up to 3% of your investment amount p.a. Clients would be far more upset if they had to write a check for them each quarter. The wealth manager can avoid this direct bill by calculating and showing the performance numbers after costs. Following is a summary of the hidden costs generated by the main product groups:
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Mutual funds: When investing in a mutual fund the client has to pay an annual management fee (deducted from the invested assets), and often also a “front-load” fee, for buying the fund. Some funds charge an additional performance fee. A first indication about the costs of a fund is given with the Total Expense Ratio (TER) as published in the fund prospect. On average, the TER of a mutual fund is between 1% to 2% a year. The one-time front load surcharge can run up to 5% of the initial investment amount.
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Hedge funds: Hedge funds have a lot of freedom in investment decisions, and also for calculating their costs. Usually the management fee is between 1.5% to 2.5% per year, significantly higher than for mutual funds. Additionally, hedge funds often charge a performance fee of on average 15% to 20% on the yearly returns as long as the performance is above the highest performance ever achieved in previous years (“High Water Mark”). Many times the wealth managers offer their clients “Funds of hedge funds” to diversify their risk. However, for this vehicle the client has to pay additional management fees and performance fees to the manager of the fund of funds. Hereby “Funds of hedge funds” can cost the client up to 5% and more per year. This is charged on top of all other fees.
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Structured products: In recent years, structured products have been heavily pushed by their issuers and wealth managers. Firstly, because the issuer can usually combine a direct investment in an asset class with a derivative, and then set the price himself. This makes it very difficult for an outsider to calculate the margin and easy for the issuer to hide high costs. Secondly, because investors are easily lured by the promise of achieving above average returns at a lower risk than with direct investments. However, research shows that this is not the case overall. Rather, simple structured products still have total costs in the range of 2%-3% per year. These can easily go up to 4% and more annually when some extra “features” are added to the product.
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Exchange traded funds (ETFs): ETFs and other index-based funds are mutual funds that are not actively managed and simply reflect a certain index of an asset class one-to-one. ETFs are very cost effective since no active fund manager has to be paid and transactions only occur when the composition of the index changes. Accordingly, the yearly costs are relatively low, ranging from 0.15% to 0.5% per year.
It is not only the choice of investment products that adds hidden costs on top of the direct fees you pay. Extra costs can also be generated through the process of portfolio management:
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Unnecessary transactions: In a pricing model based on transaction-fees, the total cost of wealth management obviously depends on the amount of transactions executed within the client’s portfolio. However, not all transactions are required. As long as you are not a trader, a high churn-rate in your portfolio is not only generating transaction fees but in fact can hurt your performance. If your wealth manager is not one of the rare successful stock pickers, you should invest in an ETF rather than investing in many single stocks.
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High spreads: The price for buying or selling a stock, bond, fund, currency etc. will always differ. The difference mainly depends on how liquid the market is, meaning how many buyers and sellers exist for the asset at a given moment. The difference between the price for buying and selling is called spread, and high spreads will cause extra costs of up to 3% of the transaction volume. Wealth managers can reduce these costs by trading in liquid markets (exchanges with a lot of buying/ selling volume) dealing in liquid products. They can also bundle transactions, such as combining currency exchanges from various clients. In this way, a wealth manager can get a better rate from the bank.