Industry funds operate on a not-for-profit basis, right? So there’s no profit margin loaded into their investment fees. Why, then, are their investment fees higher than those of the master trusts that are run to make a profit for their shareholders?

The answer is that industry funds invest quite differently to master trusts, and that different investment approach means that they incur higher costs. But it is all done for a reason, and that reason is to deliver better and more consistent returns for their members. Members, after all, are only concerned with the end result, and on that score the industry fund approach has delivered the goods.

Industry fund investment fees are higher, both in terms of what is disclosed and when adjusted for what isn’t disclosed. To explain, we need to briefly re-visit the issues of disclosure and consistency among funds.

In our March 2008 survey article, we identified what we termed the ‘Russian Doll Syndrome’. This referred to the fact that some investment products involve multiple layers of fees, not all of which are publicly disclosed by the superannuation funds that invest in them.

We now have some firm evidence to support the general principle we put forward in that article as a result of a study we have conducted into the actual and disclosed fees of 14 major funds – six industry funds and eight master trusts.

While the sample size is relatively small, these include most of the dominant funds in the accumulation sector of the industry, and between them account for about 40% of the total assets under management in the industry fund and master trusts sectors. We believe, therefore, that they can be taken as representative of the industry as a whole.

The main areas of concern we found are:

• Widespread non-disclosure of underlying manager fees in fund-of-funds products (primarily in the hedge fund sector and to a lesser extent the private equity sector); and
• An inconsistent approach to disclosure of performance fees.

Taking the second point first, the disclosure of performance fees comes down to a matter of interpretation. The law requires funds to include in their stated management costs an estimate of performance fees, but there are no guidelines as to how this is to be done. As a result all funds comply, but not necessarily in the same way. Most industry funds just include the performance fees they paid in the previous financial year, while most master trusts make some attempt to estimate the fees they might pay in the current year. There is no ‘right’ answer, and little way of knowing which numbers will be most accurate.

With the ‘Russian Doll’ fees, however, it is possible to do some analysis to come up with more accurate figures.

To get the true picture on fund-of-funds fees, we looked in detail at the funds’ use of these products and the actual managers they employed. We then compared the fees they disclosed to what we knew the actual fees to be, from discussions with several fund-of-funds managers and asset consulting firms. This enabled us to identify the shortfalls in disclosure and to quantify the effects, as shown in Table 1.

Table 1 shows for the average of the industry funds and master trusts in the study, the fees disclosed (base and performance), our adjustment to account for non-disclosure, and the ‘true’ total fee.

We can see from the table that:

• Industry funds on average have higher investment fees than master trusts, and this applies both before and after we adjust for non-disclosed fees. On our ‘true’ fee measure, the difference is about 10 basis points.
• The industry as a whole understates ‘true’ investment fees by about 15%, and this applies equally to industry funds and master trusts.

At first sight the fee differential between the two groups is counterintuitive. Industry funds have the same sort of scale as master trusts when it comes to negotiating fees and, unlike master trusts, they have no profit margins to add. The reason their fees are higher comes down to their different investment mix.

The main difference between the two groups is in their allocations to alternative investments and unlisted assets (mainly direct property). Alternative assets, in particular, command higher fees and, within those fees, include a higher element of performance fees. Over the past couple of years, at least, those allocations have been justified because the returns from alternative and unlisted assets are what have given industry funds the edge in performance. (They also account for the fact that industry funds have paid out more in performance fees, which they would certainly not begrudge.)

These differences are highlighted in Table 2. It shows that the average industry fund allocation to alternative and unlisted assets was 32% at June 2008, more than five times that of the average master trust. This was a major contributor to the material outperformance of industry funds over recent times. In the five years to June 2008, they averaged 10.7% per annum, compared with 9.0% per annum for the master trusts.

Over the past five years at least, there seems to be a reasonable link between the greater use of unlisted and alternative assets, the higher base and performance fees that strategy has entailed and the higher returns it has delivered.

A note of caution is required here. Unlisted assets, notably direct property, have undoubtedly contributed to the recent outperformance of industry funds. It remains to be seen whether the performance gap will be narrowed or even reversed over the next 12 to 18 months if the values of unlisted assets fall to better reflect the sentiments in listed markets.

That assumes, of course, that current asset allocations remain unchanged. Our observation is that industry funds and their asset consultants have generally been more active and innovative than master trusts in anticipating market movements, adjusting their allocations and seeking out new sources of diversification and added value. Over the past twelve months, in particular, they have reduced their exposure to equities and increased their cash holdings.

Past performance, as we know, is not a reliable indicator of future performance. What the past does tell us is that asset allocation is the key determinant of performance, and that higher investment fees are generally a necessary price to pay when the objective is to achieve superior net returns.