In the last of three articles we focus on question #3 – am I becoming more efficient?

The first two articles looked at understanding and evaluating total costs at a total portfolio level, suggesting that costs should be seen in the context of performance and if active management, in all its forms, is being rewarded. It’s OK to pay more if you’re getting more.  

Understanding if your costs are high or low and comparing with others is helpful. Looking at the correlation with outperformance more helpful still. What we really need to complete the jigsaw is to understand whether insights on cost have led to change, i.e., what has happened to our costs over time?

Importantly, the question is not ‘are my costs coming down’? We need to distinguish between cost changes that flow from our strategy (e.g., asset mix decisions) and underlying efficiency. 

It’s entirely understandable that costs increase over time in many funds.  The two drivers are ad velorem fees, which mean that costs are tied to the value of assets, and asset mix. There is a reasonable question about the morality of ad velorem fees, but the really big driver of change is asset mix. Put simply, if more of your assets are put into higher cost investments, your total costs will go up (and for many, particularly DB funds investing more in alternatives, asset mix will most likely drive costs up). 

For funds wanting to understand how their costs are changing, the starting point is to create a baseline and then to track changes from that baseline. An annual re-appraisal is sufficient – any more frequent risks cost analysis ‘overkill’.

CEM calculates a ‘Predicted Cost’ for each client. The predicted cost reflects the impact of asset mix changes over time. It assumes that how you implement your strategy (e.g., % active v passive) and what you spend internally and externally in each intervening year is the same in bps as it was in the baseline year, i.e., if the only thing that changed were your asset mix, what would your costs be? The predicted cost is like a rolling benchmark from which we can start to understand efficiency gains.

What we really want to see is a fund’s actual costs tracking below the Predicted Cost. How a fund’s actual costs compare with the Predicted Cost can be sensitive to a number of things, for example:

·       Outlying or unusual costs in the baseline year, that distort the baseline (funds can be made to look like superstars or mugs by outliers in baseline data). 

·       Performance fees, particularly in private markets, can have a large distorting effect on total costs in individual years.

Once we understand these factors, then we can start to understand how underlying costs are changing, how they compare with the Predicted Cost and therefore whether efficiency gains are resulting in lower costs over time. Efficiency gains come in two forms:

·       Implementation style impacts – changing the active v passive or internal v external split, or in changing the approach to investing in private markets, and

·       Simply paying less for similar assets than before.

By looking at cost trends in this way we can understand both the magnitude and source of savings.

Going right back to the beginning, the starting point for everything is, of course, high quality data. CEM has learned over 30 years collecting data using standard templates that data ‘cleaning’ is the most difficult and resource intensive part of the cost and value-for-money evaluation process. Nothing has changed with the arrival of the CTI templates. Often the data is flawed or incomplete and interventions are needed to make the data useable.

Ultimately every pound, dollar or euro taken out of pension fund has an impact. In a defined benefit scheme what is lost to cost needs to be replaced in contributions or performance. In a defined contribution scheme, fees directly affect the amount the pension scheme pays to the member. Costs matter. We should take care to ensure that costs are reasonable, that investments deliver value-for-money and that we drive efficiency gains over time. 

  John Simmonds, Client Relationship Manager, CEM