# SCM Private: Securities lending fees still a concern

## The house that ETFs built

SCM Private is a long way from the big-name asset management firms Gartmore, Jupiter and New Star, yet it has one thing in common – Alan Miller, who had worked at the three big firms before setting up his own asset management firm with his wife in 2009. The similarity ends there – SCM Private is relatively small, aiming to reach $100 million in assets under management (AUM) by the end of the year. And it exclusively uses exchange-traded funds (ETFs) as the building blocks of its portfolios. The company has three funds: SCM Private Bond Reserve Portfolio, SCM Private Absolute Return Portfolio and SCM Private Long-Term Return Portfolio. The bond fund has returned 19% since its inception in June 2011, versus 13.5% for its benchmark, the IMA Sterling Global Bond Sector. The absolute return portfolio has returned 45.7% since its launch in June 2009, versus 17.1% for the IMA Absolute Return Sector benchmark. Since June 2009, the long-term return portfolio has generated returns of 56.1%, versus 49.8% for the IMA Mixed Investment 40-85% Shares Sector benchmark. Despite using ETFs, Miller employs the same initial approach to the one he used when picking single stocks – analysing price-to-earnings, price-to-cashflow, price-to-book and yield for the components of an index. Once he has selected the asset, he chooses the ETF that is most efficient for that index. As an index investor, he no longer meets with the management of prospective investments – a situation he doesn’t necessarily see as a disadvantage. “The dangers of fund managers seeing companies is them falling in love with the companies and not being objective,” says Miller, who is also chief investment officer at SCM Private. One important philosophy for the company is full disclosure of fees, costs and investments. All too often, he says, investment firms have held back from providing full disclosure, not wanting to show their hand to the market and fearing strategy copycats. Investors deserve more transparency, particularly around fees, he says. “We’re not anti high fees or low fees. We just think any investor should be entitled to know in an easy-to-understand fashion how much something is costing them and how it is invested.” For Miller, the most important element in the investment process is asset allocation – and he sees ETFs as providing the most efficient means of allocation. There are a number of possible differentiating factors between ETF providers – for instance, fees, tracking error and liquidity. However, he views the first two as less of an issue, and doesn’t beat himself up over tracking error or small variations in cost between one ETF and another. ###### We’re not anti high fees or low fees. We just think any investor should be entitled to know in an easy-to-understand fashion how much something is costing them and how it is invested “I think people can get slightly obsessed with tracking error. What really counts in my mind is what the performance of the underlying index is going to be and then, secondly, how that particular ETF is going to perform benchmarked against that index. There’s not much point investing in something with low cost but no return. It’s a matter of looking through the index. Last year, the FTSE 250 index was up over 26% while the FTSE 100 increased by just 10.6%. You’d have been better off paying a higher fee and having the FTSE 250,” says Miller. He is more vocal on securities lending fees, however. A survey by SCM Private last year found, on average, two-thirds of gross income derived from stock lending was retained by the ETF after fees, while investors potentially bear all of the risk. Historically, this has not been made clear to investors, and Miller criticises the lack of disclosure and transparency on the issue. That should be changing, albeit not as significantly as some investors hoped for. The European Securities and Markets Authority (Esma) issued new guidelines on ETFs and other Ucits issues last year, which declared that all revenues from securities lending activities, net of direct and indirect operational costs, should be returned to the Ucits fund. Miller welcomes the change. “We were pointing out this issue for 18 months, and it was completely ignored by the Financial Services Authority [the UK regulator now split into the Prudential Regulation Authority and the Financial Conduct Authority]. We actually talked to people in Europe, and Esma produced proper guidelines, putting clients first,” he says. However, the devil will be in the detail. Esma hasn’t defined what would constitute direct and indirect operational costs, potentially leaving it open to interpretation. “You have to assume if something can be massaged, then it will be. It will be interesting to see how companies implement those words,” says Miller. There are plenty of other changes in the ETF space. Last year, a huge debate blew up over the merits of synthetic versus physical ETFs, in part sparked by regulatory scrutiny over the potential systemic risks posed by synthetic ETFs. These products replicate an index using total return swaps, instead of physically holding underlying securities. A key advantage is that tracking error is swallowed by the swap counterpary, but regulators argued that investors are swapping tracking error for counterparty risk. Ultimately, Miller is agnostic over which product to use. “The synthetics versus physicals debate got quite heated and blinkered at one point, with logic out the window. We were always prepared to do what is unfashionable. We’re lucky, we don’t have outside shareholders. It’s our own money invested,” he says. There were some implications from this regulatory scrutiny and the ensuing industry debate. Credit Suisse, for instance, opted to switch some of its synthetic ETFs to physical replication. Earlier this year, it decided to pull back from the market altogether, selling its ETF business to BlackRock. That raises new issues – competition within the European ETF space. The deal means BlackRock has almost three-quarters of the European physical ETF market, according to research firm ETFGI – a fact that led to the deal being scrutinised by competition authorities. The UK Office of Fair Trading eventually gave the deal a green light in June. Miller expresses some concerns. “In terms of the overall European funds business, BlackRock only represents a 5% market share – but, if you look at the ETF business, then it is quite a large market share.” And further consolidation is likely, Miller believes, with the UK Retail Distribution Review – which sets strict rules around how financial advisers charge for providing advice – acting as a driver, “because it tends to be the big brand names that are attractive to the public and independent financial advisers”. However, Miller says competition in the ETF space is healthy, with costs coming down. That’s largely down to economies of scale – while it took the exchange-traded product industry 19 years to surpass$1 trillion in AUM (in 2009), only four years have elapsed to reach $2 trillion. As ETFs get bigger, costs should fall further, but “there is no evidence prices are coming down in the active funds space, despite technological improvements over many years,” he adds. As well as holding ETFs in its own portfolios, SCM Private has launched a fund-of-funds Ucits ETF with Deutsche Bank. The product launched in February 2012, and Manooj Mistry, head of db x-trackers at Deutsche Bank, says the first fund is aimed at “testing the waters”. However, Miller thinks its low fee structure – fixed at 0.89% – will ultimately appeal to active investors. “We set out to design the product around what is best for the investor, and that is why we never launched a unit trust. With modern technology, investors are better off saving a layer of custody and administration fees, having the assets in their own name and getting greater transparency,” he explains. Miller is keen to explore multiple asset classes, but is wary of some newfangled, super-hyped products. So-called low-volatility ETFs are a case in point. These products consider the historical volatility and correlation of individual stocks to optimise portfolios. However, he is sceptical of any product that relies on historical back-testing to predict performance. “The performance of many of these low-volatility ETFs is simply a by-product of the fact they haven’t held financials, and financials have done pretty badly until relatively recently. You have to look through a low-volatility product and see what you’re actually paying for those companies within it. In some cases, you get higher growth for a lower price, which is good. But, with many I’ve looked at, you actually get lower growth from a higher price,” he says. However, he reserves his harshest criticism for gold – a commodity that has quadrupled in price over the past decade to a high of close to$2,000 per troy ounce, helped in part by ETFs that facilitate investor access to the yellow metal.

“The one asset that scares me more than any other is gold,” he said, speaking before the recent decline in gold prices. “There’s more froth in gold than almost every other asset put together. I find it astonishing how people with common sense think the gold price defies the basic laws of gravity that seem to apply to most other assets. The fundamental price of gold in terms of recurring demand, rather than investment demand, is probably a third of the price. To my mind, that’s an incredibly dangerous asset to hold.

“I have to be cynical. If I’m getting phone calls from the World Gold Council, then there are probably not many buyers left in the world. If the taxi driver has got it and the Gold Council is trying to arrange meetings with me, then I’m not sure who is left to buy gold. When you talk to someone and they say ‘I’ve got an ETF’, nine times out of 10 it’s a gold ETF or exchange-traded commodity. The taxi-driver test is that when he’s buying something, it’s time to get out of an asset.”

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The week in Risk.net, February 17-23 2017