After two decades in the asset management industry, David Norman and Gary Mairs, formerly chief executive of Credit Suisse Asset Management and group deputy CEO of Insight Investment respectively, saw what they perceived as a big opportunity.

After two decades in the asset management industry, David Norman and Gary Mairs, formerly chief executive of Credit Suisse Asset Management and group deputy CEO of Insight Investment respectively, saw what they perceived as a big opportunity in the UK retail market for something genuinely customer-focused.

They launched TCF Investment earlier this year, and the firm will soon be launching its own range of low-cost multi-asset fund of passive funds with different risk/return targets, subject to approval by the Financial Services Authority, the UK regulator.

The fragmented nature of the mutual fund industry as well as the complexity of some financial products have resulted in the industry losing sight of its customers, Mairs and Norman told WealthBriefing in a recent interview.

The mutual fund industry developed to allow ordinary investors, who might only have a modest amount of capital, to pool their investments and access assets such as stocks more easily. However, a 30-year period in which the industry has grown enormously, and information availability has exploded, hasn’t put the pressure on price or delivered the economies of scale normally associated with a competitive industry, according to TCF Investment.

Expense ratio

In 2008 the average total expense ratio (TER) for an investment fund was 1.65 per cent, compared to 1.52 per cent in 1998 (source: Lipper FMI). And in the UK, funds managing $75 million – $400 million have a median TER of 1.66 per cent, while funds of over $1 billion have a TER of 1.67 per cent (source: Morningstar).

Costs are rising despite improvements in technology and customers don’t share in the benefits of scale as funds grow in size, said Mairs and Norman.

Meanwhile, the issue of cost generally has been sidelined to performance, and disclosed costs remain opaque because the TER does not include dealing costs within the fund. This means that the actual cost of a single equity fund is around 3.1 per cent per annum, and for a typical fund of fund is around 4.7 per cent per annum, according to TCF (source: Lipper Fin Express 2008/09).

The total cost of a TCF Investment fund will be around 1.2 per cent per annum – including all dealing costs – and this will reduce as the fund grows.

“The idea that one ought to be invested in the best performing fund regardless of cost is illogical, because the nature of costs means they have a direct bearing on returns,” said Norman. “Past performance isn’t a guide to the future, but costs are.”

The danger of ignoring costs is illustrated by the fact that if the performance of the 25 per cent highest-cost fund of funds is compared with the 25 per cent lowest-cost fund of funds in the IMA balanced managed sector over a 5-year time period, the lowest cost ones outperform the average by 1.3 per cent per annum while the high cost ones underperform it by almost 1 per cent per annum, says TCF (source: Morningstar).

Informal cartel

The information advantage and the absence of a collective agent on the buying side have allowed the industry to operate as an informal cartel, said Mairs and Norman.

According to TCF, this has resulted in product proliferation: in the UK there are 400 funds in the three main UK sectors and only 103 stocks in the FTSE 100 to choose from, and in Europe  there are now more mutual funds than large companies in any of the main indices (source: TCF Investment) . And although it seems intuitive that investors would wise up to this over time, a powerful lobby for the industry as well as a badly incentivised commission system for advisors mean mutual funds have continued to attract assets, said Norman and Mairs.

This last factor is changing with the introduction of the retail distribution review from the FSA which will abolish commission at the end of 2012, and the industry “will find it quite difficult”, said Mairs. However, he emphasises that is not to say there isn’t room for active managers who genuinely add value through outperformance, after all costs have been taken into account.

For TCF Investment, the most important factors for an investor to focus on are asset allocation and minimising costs.

“What’s really important is being in the right mix of stocks and bonds depending on an investor’s attitude to risk and time horizon.” said Norman, “This is the biggest driver of return.”

Investment frontier

The goal is to bring the investors as close as possible to the efficient risk/return frontier. Many investors take on too much risk for the return they are targeting, he said.

The recent fast-paced growth of ETFs and other low cost passive funds makes achieving a given asset allocation on a low-cost basis possible.

For the decade through to the end of 2009, the compound annual growth rate of ETF assets in Europe was 90.5 per cent, and at the end of January 2010 the European industry had 896 ETFs with 2,468 listings (source: iShares).

However, as with any new product there is the risk investors won’t fully understand what they are investing in, especially as ETFs are often marketed as being simpler than they actually are.

“There is the idea that if I buy a tracker, I will track the market,” said Norman, “but this isn’t really the case.”

“Firstly, there is the issue of which index to track, especially important in emerging markets where people are not as familiar with the available indices. Secondly, there is the danger of concentration – that an investor is more exposed to a sector than he/she realises. Thirdly, there is the question of how the tracking is actually achieved: is it achieved by investing all the stocks in the index, or via swaps, and what is the counterparty risk, and what do functions such as “dividend enhancement” really mean?” said Norman.

TCF’s proposition is based on the idea that ETFs and passive funds, as with all investment, require a certain level of expertise as well as diligent research, but used well can be a beneficial tool for retail investors to gain exposure to a range of asset classes on a low-cost basis.