Are you paying twice for the investments you hold?

Over the last ten years, a trend of financial packaging and repackaging has emerged. Whilst the finance industry claimed it helped lower risk and improve diversification, unfortunately for many firms, the main reason for this kind of financial engineering was to increase fees and revenues.

Following last year’s melt down of the financial system, governments, corporations and private individuals have begun to pay far more attention to the underlying investments they hold. One of the main casualties of this process is likely to be Collective Investment Funds, run by Financial Advisory Firms - so called ‘broker funds’.

The basic concept of a broker fund is a Collective Investment Scheme established by a Financial Advisory Firm. The Financial Advisory Firm will then contract out the management of this fund to a fund manager. The fund will charge an annual management fee to cover the costs of administration as well as the investment manager’s fees. The concept of broker funds can be a sound one; it allows firms to better diversify a client’s portfolio whilst being able to keep an eye on the underlying assets being used by the fund manager. Unfortunately, the concept is open to abuse by less scrupulous firms. In too many cases these funds charge a high annual management fee and advisors use them not to better diversify a portfolio, but simply to generate more fees from a client’s investment. Furthermore, it is not unknown for the investment manager to be selected not on track record or experience, but on price, again increasing the bottom line for the unscrupulous firm. Some fund managers simply select a series of other collective investments (known as a Fund of Funds). This leaves unsuspecting investors paying not one, but two (or more) sets of additional charges and hidden commissions.

Often clients may not know that they have broker funds in their portfolio. Some smaller asset managers will either offer to white label their own funds for a Financial Advisory Firm to sell, or simply offer to pay the firm additional fees to place their clients’ money into their funds. Interestingly Bernard Madoff’s funds paid commissions to the broker, read into this what you will.

Broker funds tend to be very popular when times are good. Often clients will not notice the underperformance of an asset compared to it’s benchmark. However, in difficult times these funds tend to drop much further, and faster, than the underlying indices and may never recoup the funds that have been lost.

With many staff being laid off from investment banks and fund managers alike, there has been an explosion in the number of new fund companies setting up, offering a wide variety of alternative investments from art buying to forestry management. Many of these funds pay large hidden commissions to advisors reducing the potential return to the investor.

This presents the question – “What can I do to prevent this from happening to me?”

Firstly never start an investment without seeing a portfolio recommendation from your Financial Advisor. It is imperative to run some basic checks on the assets being recommended to you. Any fund in the world worth holding in your portfolio will be independently rated by Morningstar. Morningstar rates funds from 1 to 5 stars based on a number of variables from performance to charging structure. It would be difficult for a Financial Advisor to justify an investment into a fund less than 3 star rated. Morningstar ratings are freely available to anyone via www.morningstar.co.uk.

When it comes to investment funds you should ask yourself two questions. “How good are the managers and how much will their expertise cost me?”

All funds domiciled in well regulated jurisdictions are required to publish a Total Expense Ratio (TER). A fund’s TER will give you an accurate picture of the charges you are actually paying including annual management fees, high water marks (extra charges if the fund performs well) and commissions to advisors. Whilst some funds, such as simple equity trackers, will have a low TER of less than 1 percent some more aggressive investments such as hedge funds may have a TER of more than 2 percent. If a Fund has a TER of more than 2 percent, you should ask yourself the question – “How will the manager generate sufficient returns to justify this?”

I have come across Financial Advisors who have told potential clients that their funds are exclusive and can only be accessed by their clients, however this argument makes little sense. If you were running a highly successful investment fund, would you not open it up to a retail sector worth hundreds of billions of dollars? Indeed this basic principal of capitalism is the basis for the entire asset management sector. Investment managers who consistently outperform their peers will find very quickly that their fund can attract large amounts of additional capital (and therefore fees) with no need to advertise. Indeed out performance is an advertisement in its own right. In the UK broker funds are, by law, only available to ‘experienced investors’ and as such, they are not as heavily regulated as retail investment funds. Without this legal protection offshore it is far easier for unscrupulous advisors to establish their own range of investment funds, place all their clients’ money within these funds, and in turn increase their profits often at the expense of their clients.

Indeed this problem is not simply limited to Financial Advisory Firms. Some large private banks will establish similar arrangements with investment banks, often across different companies to make it more difficult to spot.

One of the problems with investing in funds, especially offshore funds, can be the large minimum investment requirement. Many offshore funds require a minimum investment in excess of £50,000, so for smaller investors it can be difficult to achieve suitable diversification. However, investing through an investment vehicle such as a bond, can allow you a far better degree of diversification. For instance most personal portfolio bonds will allow you to hold individual investments in offshore funds of just £5,000 per investment. This can allow you to hold up to ten different investments in an account of just £50,000. Whilst diversification is an important part of any investment approach, the more diversified the more it costs the investor. In most circumstances, there is no need to hold more than 10 different investments in your portfolio. Whilst these investment vehicles will charge an annual management fee, they allow you to go in and out of a wide selection of investment funds without paying any further commissions.

Some Financial Advisory Firms advise clients to hold broker funds through portfolio bonds. However you should ask yourself, “If I’m paying portfolio bond charges, as well as a fee for investment management should I also be paying for a broker fund to hold a ‘fund of funds’ all charging me for management?”

Obviously even the best Financial Advisor cannot get it right all the time, but loading an investment with seven percent (or more) charges limits potential growth in the good times and is potentially disastrous in the bad. Indeed this type of packaging and repackaging of financial assets is exactly what got the world economy into the mess it’s in today!