Investing in funds doesn't come cheap

Investing in Middle East's mutual funds can be expensive and investors here may be among those paying the highest fees in the world.

According to a recent Lipper fund expenses report, emerging market funds consistently have the highest charges when compared to Europe and the US.

Though no comparative studies have yet been done on the Middle East, it can be expected that in a nascent and a small market such as the Gulf, where advantages of economies of scale do not apply, fund expenses will be similar to those in emerging markets, according to Dunny Moonesawmy, head of research, Western Europe and Middle East, Lipper, a Reuters company which tracks funds.

For retail share class of Mena funds, the total expense ratio (TER) could range between approximately 1.75 per cent and 4 per cent annually, says Farah Foustok, Dubai-based chief executive officer of ING Investment Management, Middle East.

And that is high by international standards, she adds.

TER incorporates all expenses incurred by the fund and lower it is, the better it is for the investor. It is expressed as a percentage of the fund's total assets.

According to Steve Gregory, director of technical services, Holborn Assets, mutual fund companies market their products in the main indirectly to the public (through brokers). The banks may sell their products directly to the public, but also via intermediaries.

And given the various fees and charges that investors pay here, including high subscription, redemption and performance fees, Gregory says, "it's not cheap to invest!"

Many of the investors may not be aware of what are all different fees and expenses and how they all add up to have an impact on the return of the investment.

Charges

The majority of the TER is made up of the management fee, which for the region, varies annually between 1.5 and 2 per cent in the region. TER also includes marketing, administration and operation charges and, in many cases, early redemption fees and performance fees.

"On average, you will find fund managers charge about 1.5 per cent as management fees," says Shakeel Sarwar, head of asset management, Securities and Investment Company (SICO) BSC, Bahrain. "On the lower end, you will find some managers charging 1 or 1.25 per cent. Anything more than 1.75 per cent is high even by regional standards and one should be careful."

The expenses on marketing, administration, custodian, brokerage and audit are borne by the fund and that affects its value.

"Brokerage expenses are a very important element of that," says Sarwar. "Some of the regional funds that have high turnover rates and are managed by fund managers with a short term trading mentality may end up paying around 3 to 5 per cent per annum as brokerage expenses — yet these expenses are not disclosed to the investors as very few funds in the region are audited by independent auditors and/or choose to report their TER."

Furthermore, the investment management, brokerage and custody-administration functions are generally performed by the same entity for most of the regional funds" explains Sarwar.

"Investors should, therefore, insist on investing in funds that are domiciled in recognised jurisdictions and have independent service providers, that is, brokers, custodians, administrators etc.," Sarwar adds.

At the time of entry and exit, there are subscription and redemption fees.

Subscription fees

The subscription fee ranges from 2 to 5 per cent for most of the funds in the region.

"This is a huge amount," says Sarwar. "Depending upon the type of investor and especially the amount that he is investing, he can negotiate and reduce these fees. I don't think anybody should be paying more than 2 per cent as subscription fee."

In some cases, retail investors even end up paying 5 to 7 per cent for international funds that are being sold in the region through third parties, he points out.

"You don't need these intermediaries who are selling these products and making such high commissions. You can go to the internet and buy these funds directly from the sellers and pay a maximum of 2 per cent and even that can be negotiated if you are investing a larger amount," Sarwar says.

A lot of funds have a back-end load, which basically means that whenever you redeem or exit from the fund before a certain time period, for example six months or one year, you pay between 1 and 3 per cent.

"This again, in my view, is an excessive fee," Sarwar says.

Then there is, especially in the regional funds, what is called performance fees. The investors should be paying such fees for only those funds that have solid track records and have over time done better than their benchmarks and peers. Ironically, many fund managers with lousy track records continue to charge these fees to their clients, observers say.

"The concept of performance fees in this part of the world is quite absurd," Sarwar says.

For example, he explains, if the market is up 50 per cent and the fund is up 30 per cent during the same period, it simply means the fund has underperformed.

"But if the fund's hurdle rate is 10 per cent over 10 per cent, it means that the fund manager would still be charging 2 per cent as performance fees, despite the fact that the fund massively underperformed the market. The fund managers get away with it in this part of the world because of the demand supply imbalance. But if a fund is charging performance fees you basically have to make sure that the fund managers deserve this fee."

There is another aspect with regard to performance fees that the investor should be careful about. It is important to know whether the fund manager is charging it on annualised or on monthly basis.

"What they do in many cases here is they charge performance fees on a monthly or quarterly basis," Sarwar says.

"In a lay man's language, this basically means that the fund manager may continue to charge performance fees even in a downward trend because of positive returns in some periods. Investors, therefore, should shy away from such funds and should insist on investing in funds where such fees are charged only on a yearly basis."

Last but not the least, the investor ought to know whether the performance fee being charged has a high watermark or not.

The concept of high watermark goes like this: In 2007, the markets peaked, for example, 50 per cent. So, most of the Net Asset Values (NAVs) of funds peaked in 2007. The fund managers charged performance fees at the end of 2007 and that's fair, says Sarwar.

Then in 2008, when the markets lost about 50 to 60 per cent of their value, the NAVs fell well below the 2007 NAVs. Now in 2009, the NAVs have increased by about 20 or 30, depending upon the fund returns. So a lot of fund managers without a high watermark are charging performance fees this year and that in Sarwar's view is criminal.

"You charge performance fees at 2007 level, then in 2008 the investors lost 60 per cent and now they have not even recovered half of what they lost and you are still charging performance fees," says Sarwar. "The concept of high watermark is that I should not charge performance fees until my NAV reaches the same level or point where I last time charged the performance fee, which is end 2007 in this case," he elaborates.

Retail investors need not despair. If they are badly burned by poor returns on funds despite paying high fees they can invest in low cost index funds or exchange traded funds (ETFs) offered in different markets by going to their websites or getting their offerings through financial consultants. If ETFs are launched in Abu Dhabi, as announced earlier, investors will have that low-cost option at home.

Illustrative example

You may not realise it at the time of investing, but over time, paying fees and charges can impact your returns at the end of the day.

Let's illustrate with a hypothetical example using Mutual Fund Fee Impact Calculator devised by www.Investored.ca of how much fees and charges eat up an investor's returns (see chart).

Take, for example, an investment of $1,000 in a balanced portfolio for a period of five years and the market returned an average of 10.02 per cent and the fund had a return of 7.52 per cent.

If you did not pay any fees and earned the market returns, you would have made $1,611.97 on the $1,000 investment.

After paying the fees and charges, that include, for example, 2.50 per cent of management, administrative, marketing, brokerage, performance fees and a subscription fee or a sales fee on a front end load rate of 3.50 per cent, you have made only $378.61.

The subscription fee amounted to $35 and, other fees, including management and miscellaneous fees, added up to $146.84, totalling $181.84. The remaining $51.52 was what the calculator terms as "lost return potential," or whatever gains you have given up. With almost 40 per cent gone to pay fees and in "loss return potential", it's better if you did your homework before selecting funds.