Lower fees mean higher returns

Ron Hodge is the CEO of InvestSMART Group Limited and my boss, so obviously a conflict of interest here, but I thought it was time we spoke to Ron as a CEO of a listed company because the shares have come down quite a long way. So they haven't been a great investment over the last little while. In the past five years they've gone from 30 cents or so down to currently 5.96 cents. It hasn't been a great ride for shareholders and the reason simply is that trailing commissions, grandfather trailing commissions which are going to be abolished.

The question is what's the plan to replace those? Apart from hiring me and getting me to run Eureka Report, there's more to it than that, obviously. Eureka Report as we know, is a part of InvestSMART, so is Intelligent Investor. But the key growth part of the business is professionally managed accounts.

Anyway, here's Ron Hodge, the CEO and Managing Director of InvestSMART Group to explain how that works.

Table of contents:
Lost revenue from grandfather trailing commissions
Company history
Capped fees and impact on business
Future of funds management
Intelligent Investor and Eureka Report performance
Accelerating growth

Ron, let's confront the elephant in the room. How much revenue will InvestSMART lose when grandfather trailing commissions are ended, and when will that be?

Grandfathered trailing commissions end on the 1st of January, 2021, so next January. The fund managers send us cheques for our commissions every month and come January, we will no longer get those. In total that represents around about, you know, the market's gone up a bit and down at the moment as you know, Alan, but it's around about $4-4.5 million in lost revenue from those grandfathered trails.

What proportion of your total revenue is that?

It's probably about 40 per cent. But what most people don't understand is we rebate a lot of those trailing commissions, so we rebate about 30 per cent of those. Net-net from a profit point of view because those costs also disappear, is about $3-3.2 million.

Okay, and so what proportion of revenue is that?

The proportion of revenue is about 40 per cent of revenue. If you extrapolate it out, we think that we'll break even this year as we've told the market and we think we'll be able – actually we’ll make a bit of money this year. Next year we think that we'll still be able to break even, 2022 is the big year where we lose those trailing commissions for a whole year. And we think we'll probably go down a little bit and then 2023 we'll be back to being profitable. But we've got plenty of cash in the bank and we've got no debt, so we don't really think that's a big problem going forward.

How much cash have you got?

About $5 million in the bank.

Probably a good idea to go back into history as to how this trailing commission business started. What is it then and what's the history of it?

We started the business in 1999. In the beginning, it was called Float News and we used to do IPOs and then the tech crash hit early 2000 and so we moved into managed funds as well. What we're really good at is distribution and helping retail mum and dad clients. We don't really deal with advisers or institutions, it's all direct to mum and dads. We got into managed funds and helping other fund managers distribute their funds and the fund managers as a result of those agreements, paid us a trailing commission of usually around about 40 basis points or 0.4 per cent and we collect that every year from the fund managers.

But the Royal Commission, well FOFA in 2013 actually stopped those commissions, but then they grandfathered them, so they said any commissions being paid before that would need to be paid. And then the Royal Commission, which started as you know, at the end of 2017 and concluded sort of like early 2019 actually repealed that and advised the government or encouraged the government to abolish grandfathered trailing commissions as well. And so the government came out and did that and said they’d do that by the 1^st of January 2021.

But the original deal, the original business structure was that you would rebate most of those trailing commissions. Right? You weren't just keeping all of the trailing commissions. Tell us about how the, how the business was originally structured?

Originally, Trail Cap, that was what that program was called. We rebated a portion of trailing commissions back to our clients and how that worked was we kept an administration fee because it's painful actually dealing with the fund managers and collating all these commission statements. And we rebated 50 per cent of the money after that. Basically, I think it was like $297 was the cap, and then we rebated 50 per cent above that cap back to the client. In essence, what happened was it's about 30 per cent. Overall, it’s about 30 per cent of the money we collect in trailing commissions goes back to our clients, which is money they would never have seen before because that money is paid to us by the fund managers as part of that original distribution agreement.

Particularly after FOFA, there was a couple of changes to the business. You left and the business was sold to Fairfax. Can you give us a potted history of what happened during those years?

Yeah, so we sold the business to say, Fairfax in 2013 no, no – I'm too old, 2007, we sold the business to Fairfax. Just before the GFC, so 1st of October, 2007 we sold the business to Fairfax. Then Fairfax had it for about five years, but during that GFC time, Fairfax lost a lot of media businesses. They had a lot of trouble with their main assets and so they really didn't give much loving to InvestSMART. Then in 2013 Fairfax did a review and decided that they would sell off a number of businesses they had bought in the heyday. And InvestSMART was one of those and so we bought that back in actually on the 1st of October, 2013 so exactly six years.

At what point along this journey did you come to think that the grandfathered trailing commissions would be abolished and you had to do something about replacing that revenue?

Well, to be honest, Alan, I always thought that, you know, we'd been rebating trailing commissions back to our clients for nearly 20 years. Trailing commissions and those sorts of percentage-based fees are insidious. Once FOFA came out in 2013 and abolished them then we thought it was pretty certain that at some stage, either the grandfathered trails would run off or they would be revisited and abolished at some stage. In 2013, we started looking at doing our own version of what some people called Robo Advice. But basically, putting together portfolios of ETFs, Exchange Traded Funds, for our clients at a very low rate. And so rather than providing everybody else's managed funds, we’d just provide the best version of our managed funds to our clients, and so we started those in 2015. We’ve just celebrated our fifth year for most of those funds.

Is your expectation, does it look like that revenue from those funds will replace the $4.5 million, I suppose, in total revenue from the Trail Cap.

Yeah. So we think that, I mean, it took us nearly four years to get $100 million in our products. It then took us, we thought that in February this year, just before the recent calamity in the markets, we were at $183m and we thought that probably by the March quarter, which we just released, we would get to $200 million. So to put that in perspective. It took us three to four years to get to $100 million, it took us 12 months to get to $200 million. To replace those grandfathered trails we're going to lose by the 1st of January, you need about $600 million in those funds. We don’t think we’re going to get there this year. But we thought we would get there, it depends on what happens to the market, but that acceleration in that growth. You used to get like $1 million a month, and then it was $2m, then it was $4m month. January, February this year, it was getting to like $10-12 million a month into those funds.

And I think we’ll get back to that stage and I think we'll get to that $600 million in the next couple of years and I think we've got plenty of money in the bank and no debt that we can get there quite easily. So yes, absolutely I think that we will replace that net revenue of about $3.5 million through our funds management business.

In 2018, you changed the way those funds work to be capped fees, $451, 0.55 per cent up to $451 and then capped after that. Tell us about how fundamentally that changes the business and what does that mean? Because it's no longer a sort of what you might call a traditional funds management business where the FUM, the funds under management count?

Correct. Great question. For us it's similar to our trailcap program it’s about, we think percentage-based fees are a problem because the larger your balance, the more fees you pay, which it doesn't actually cost us any more to administer the portfolios of ETFs. And so we brought in that fee of $451, as you said, a year or so ago. And so what it fundamentally does is it changes our business to being more of a subscription business. So along with Intelligent Investor and ER where we charge a subscription, so now similar on our funds management side. We can't just have a fixed subscription fee because then clients with smaller balances, like if you're putting in $10,000 and we charge you $451 that would be an excessive fee, that'd be 4.5 per cent. And so what we've done is we've made it a basis point fee of that 0.55 per cent up to $82,000, which then is for $451 and then that’s capped. And so that's much better for our larger balance clients but it doesn't impede our smaller balance clients.

Obviously, most of the people in this business get percentages and that's how the business works, everyone makes a fair bit of money. Having looked at it for now, a bit more than 18 months and worked that business, do you believe that it's going to work as a business?

Absolutely. I mean, the more people find out about capped fees, the more people are coming to us. I mean it makes complete sense because those funds, those managed funds, because of low fees, beat pretty much 90 per cent of all other relevant or respective fund managers in those peer groups, and it has done for the last five years. So, you know, it's fees rather than, people being able to pick the right stocks year in, year out. It’s a hard one Alan, because we've got to get out there and let everybody know that what they've been told for the last 10, 20, 30, 50 years about performance and paying higher fees and the higher your fee you would think the higher your performance, but it's completely untrue. The more people that we convince and we show them on paper, and we've been doing it for 18 months now as you said, and you can see that people are starting to wake up to the fact that high fees do not mean higher return.

And so low fees actually do give you better performance, and if you can cap those fees, you get even better performance. As we always say, you know, compound your returns, not your fees, so grow your money, not your fees. And I think the more we get that message out there and the more people that understand that the more people will come to us and the faster we’ll grow that subscription. For us it's just bums on seats. If you go back to that $3.2 million net, we lose from trails, that's about 6,000 bums on seats at $451. I think that's very easily achievable once we get the message out there.

Is it fair to say that somebody who invested in InvestSMART as a listed business now is basically betting that you're right, that the future of funds management to some extent is about capped fees and not percentages?

Yeah, absolutely. I think that people will be looking at our business as a completely different business than your traditional financial planning business, an IOOF or a fund management business. A lot of those lines are blurred now and everyone’s like, even a fund managers how hires advisers, but that fund management business as a whole, generally goes after advisers and institutional money, wholesale money. We're going after direct clients. We believe the capped fees are the right way to go, and I think you're right. I think there's a few things in that question you asked, Alan.

I don’t think it’s just on capped fees. It's also, whether you think that the adviser model, which is not pyramid selling but an adviser has 200 clients. The fund manager comes to the adviser and the adviser sells to those 200 clients that fund. We actually miss out all those middle men and we go straight to the client with a good funds management product. So direct to market at a low cost is what you're betting on with our business.

I think it's also important to say that, you know, some of the problems with those traditional funds management businesses, all those risks are, you have a rock star sort of fund manager, who leaves those fund management businesses and takes a lot of the fund with him, takes the adviser market with him and takes those institutional market with him, we don’t have that risk. Because we trade in ETFs, we are the market. And the other thing is that when the market goes down 30 per cent, if you’re a bums on seats subscription business of $451, our money doesn't go down with the market, or it doesn't go down as much. It might not grow as much now because the market's come down, but we don't lose a lot of money because we're a subscription value. If that makes sense.

Yeah. Well, of course, so that when the market falls 30 per cent or whatever as it did in February/March, the fund managers who rely on percentage-based fees suddenly had a 30 per cent drop in their fee income because the value of their funds under management fell by that much.

Correct, and we don’t have that because we charged $451.

Yeah. Let's just turn to the other two businesses that are important to you, the Intelligent Investor and Eureka Report. How are they going?

Yeah, they’re going really well. The interesting thing is in COVID-19 lockdown people have obviously a lot more time on their hands, they want to better themselves through learning something different, whether that’s taking up an instrument or language or learning about investing. It's been a real bonus for that subscription business, this recent pandemic. To give you an idea usually in a normal period of time we had 1,400-1,500 trials. We do a 15 day trial to those subscription products, the Eureka Report and Intelligent Investor. That blew out to about 4,500, so three times in February and it got over 5,000 in March and the conversion rate has kept up, so we're putting on a lot more subscribers. That business is going really well.

In October, last year, you're appointed Berkshire Global Advisers to advise on options for the business and obviously there was a possibility of selling it or doing an equity partnership or something. What happened there? Did anything come out of that and are they still engaged?

No. So for us, it's all about growth and you know, going back to the bums on seats for the funds management, which is by the way I call our professionally managed accounts. The faster we can grow and get that message out to the market, about capped fees, direct to retail, you know, low fees give you better returns, the better for us. For us, what we did and as a board, we decided to engage an advisory company like Berkshire to go out and see if there are any partners out there, now whether that was a commercial partner or an equity partner, to see if we could accelerate the growth in the professionally managed accounts. Now that sort of partner, the ideal partner looks something like someone who had better brand equity than us, was better known, had a better retail direct reach to mums and dads.

To give you an example, we thought some of the industry superfunds were ideal partners because they deal with superannuation products. We deal outside of super. They deal with mums and dads inside of that super, we deal with mums and dads outside of super, we have a lot more education than them and a lot more engagement through our tools and our portfolio manager and our content and they need that. And so we thought that those sort of guys were the perfect partners, and there's some other ones as well. We talked to a lot of these sort of businesses. I think the problem we faced, Alan, was that a lot of people have, especially in the financial services industry at the moment, have their own set of problems. The industry superfunds had the problem of getting way too much money.

Now they’ve got the problems of people pulling money out through this $10,000 drawdown from the COVID-19 policies. A lot of the other financial services companies had problems with the Royal Commission and the fallout of the Royal Commission. I think there's a lot of conversations still ongoing. But for us, it's just business as usual and if anything comes of it and we can find a partner that would accelerate our growth, then we would look at it. But it doesn’t necessarily mean we’re selling anything. It's just a process of seeing how we can accelerate our growth and maybe that's actually a commercial deal.

Right? Is that still on the table or not?

Well, we're no longer engaged with Berkshire as such. But as a normal business, we continue to talk to many parties, and if we can find the right partner to accelerate growth, we will or we might not.  But that doesn't necessarily mean it's some sort of M&A sort of thing. It could actually just be a commercial deal, like any part of our business, so it’s ongoing it’s just business as usual for us.

Yeah and the focus of the business is to grow the professionally managed accounts side of things and to as quickly as possible get to $600 million. Is that right?

Yeah, correct. I mean, well for us as you rightly pointed out Alan its bums on seats so as quickly as we can get to 6,000 bums on seats paying us $451, then it’s sort of like $3.2-3.5 million, and then it's onwards and upwards. At the end of the day, we have like a database of 600,000 people. You’ve got 10,000 subs. We've got 22,000 investors in those grandfathered trails that we’re now talking to about our products. It's not that we don’t know these people, it's a process of educating, we're in the business of selling trust, so we have to get them to believe that, you know, lower fees means higher returns, which, you know, they've all been brought up for the last 50 years on the opposite. It's just a slow process of convincing people and showing them quarter in, quarter out that lower fees actually do mean higher returns, and that’s in fact, the hard part.

And as you say, it’s not about $600 million it’s about 6,000 people, individual accounts.

Correct, absolutely.

Good to talk to you, Ron. Thanks.

Thank you very much, Alan, cheers.

That was Ron Hodge, the CEO and Managing Director of InvestSMART Group.

Related links: Click here to read InvestSMART's report, How fees can destroy your wealth