Understanding The Cost Of Investment Management by Commonfund Institute
Few aspects of investment management are more important for fiduciaries than an understanding of the costs paid for the management of the perpetual funds for which they have responsibility. Indeed, astute management of costs can make the difference between mediocrity and superior performance in otherwise identical portfolios. But unlike other factors that affect investment returns, such as asset allocation and the many types of operational and investment risk, costs are almost certainly the least well understood. In this paper, we introduce the various types of costs that investors pay – both disclosed and undisclosed – and provide representative ranges for each type of cost. Our aim is to guide fiduciaries as they strive to fulfill their duties under common and statutory law and to provide investment managers with a guide to best practice.
Commonfund Institute’s national surveys of endowments and foundations confirm a low level of understanding with respect to costs. To take one example, of the 832 U.S. institutions of higher education participating in the 2014 NACUBO-Commonfund Study of Endowments® (NCSE), the 717 that responded to the suite of questions regarding costs incurred in managing their investment program estimated a median all-in cost of 50 basis points, or 0.5 percent. But very few of these institutions were able to provide specific breakdowns, although most could name the components of those costs by category. And while some cost categories were clearly familiar, others were cited less frequently. For example, 86 percent said that their cost total included asset management fees and mutual fund expenses; 64 percent cited consultant and outsourcing fees; and 56 percent included direct expenses. But only 18 percent included incentiveand performance fees paid to asset managers, despite
the fact that nearly 85 percent of NCSE respondents, or 704 institutions, reported having asset allocations to alternative investment strategies. Clearly, a gap exists between practice and understanding with respect to certain types of costs.
In a similar vein, in early 2015 Commonfund conducted a survey of the fiduciaries – financial officers and trustees – attending the Commonfund Forum annual investor conference. In response to the question, “What are the total fees and expenses you pay to investment advisers, managers, consultants and custodians (in basis points)?”, 81 percent of the 193 survey respondents estimated their annual costs at less than 100 basis points, while 19 percent said their costs were greater than 100 basis points. Eighteen percent of respondents estimated their costs at less than 50 basis points, while 14 percent put them at over 130 basis points.
These data points support a few preliminary observations. As the NCSE responses point out, the categories that are included in overall cost estimates vary widely. In addition, the fact that almost 15 percent of NCSE participants did not provide cost data at all suggests that they may not have known what their costs were or were uncertain about them. A more detailed estimate of total costs comes from Commonfund’s investor services group, which analyzes costs for some 80 client organizations each year. The results of these analyses suggest that costs are significantly higher than the median 50 basis points reported in the NCSE. In general, average costs appear to be no less than 100 basis points and can range up to 175 basis points or more for more complex portfolios. It is this level of detail that is missing from the self-reported numbers, and which we hope to illuminate here.
A range of factors may cause costs to vary from institution to institution, even among those of similar size and type. But it is clear that a fuller understanding of the costs associated with managing institutional nonprofit funds is needed. In this paper, we attempt to accomplish three goals:
- To provide an overview of the various types of costs, both disclosed and undisclosed, that nonprofit institutions are likely to incur in investing their long-term pools, together with representative cost ranges;
- To help fiduciaries to understand the derivation of these costs; and
- To enable them to address well-informed questions about disclosed and undisclosed costs to investment service providers.
Understanding The Cost Of Investment Management – Why Costs Matter
Fees are known – indeed, they are frequently set out in detail in a manager’s or service provider’s invoice – and can, therefore, be analyzed and controlled. Costs, on the other hand, are not necessarily invoiced and can be much harder to understand and control. The problem is exacerbated by the fact that different types of long-term investment pools report their investment performance in different ways. Nonprofit organizations such as colleges, universities, independent schools, foundations, operating charities and healthcare organizations generally report their investment results net of costs. The practice among public pension plans, however, is typically to report returns in gross terms. Because fees and costs – both disclosed and undisclosed – determine what institutions get to keep and spend in support of their missions, it is important to understand their nature and range. Furthermore, as a fiduciary matter, several compelling reasons exist to support a better comprehension
of cost issues:
- As transparency becomes the norm in the nonprofit sector, driven by the disclosures required by the expanded IRS Form 990 and by social forces that encourage increased openness, trustees and senior staff are expected to understand the total cost that their organization pays for investment management as part of their fiduciary duty of care.
- The “endowment model” of a highly-diversified portfolio with a high allocation to illiquid investment strategies, frequently in the form of limited partnerships, often contains compensation structures that include incentive fees and other forms of potential income for the general partner, many of which are not clearly disclosed. It is incumbent upon fiduciaries to have some understanding of what these fees are likely to encompass and what their range could be.
- Even in traditional long-only investment strategies – such as, for example, core fixed income – where the dispersion of gross returns is relatively narrow, higher asset management fees can mean that a manager that would rank in the first quartile in terms of gross performance may become just average when viewed in terms of net performance after fees.
- High costs are more visible when markets are trending down, since they add to losses. If, as many investorsexpect, the next few years will be characterized by more subdued returns after years of high performance, fees will be felt more acutely.
- In a purely economic sense, institutions should be willing to pay more for “alpha”, or excess returns due to manager skill, than for “beta”, or market returns. Beta is readily available at low cost through passive or indexed investment vehicles, so it is important not to pay active management fees for simple beta exposure.
- Finally, while fees are rarely noted in surveys as being among the most important criteria in manager selection, they are frequently cited as one of several key deciding factors.
The fiduciary duty to understand and manage costs is embodied not only in common law principles but also in statutory law. The Uniform Prudent Management of Institutional Funds Act (UPMIFA)2, the dominant law governing investment, spending and delegation from donor-restricted funds, demands prudent oversight of the cost of investment management. Section 3 of UPMIFA directs an institution to incur only “appropriate and reasonable costs” in managing its investment portfolio. Determination of what satisfies this standard is left to the fiduciaries, who are expected to act “in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.”
Furthermore, as we have noted, the revised Form 990 extends its reach to the issue of costs, asking, among other queries, what an institution pays for portfolio management.
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