Investment Bulletin – April 2011

The Hidden Investment Costs That Destroy Your Wealth

The financial pages of the press are full of the latest new fund offerings and these adverts may quote the annual management charge (AMC) that you would pay within the investment.

We believe that there is very little awareness amongst investors that ‘what it says on the tin’ may not necessarily reflect all of the charges that are taken from a fund.

When shares rally strongly, little attention may be paid to the amount that is deducted in charges but when markets are falling or growth is lower, the costs paid by investors account for a greater proportion of their total returns.

Understandably, investment companies need to levy charges to cover their costs and return a profit. Even something as simple as sending out a statement costs money, particularly when there are tens of thousands of investors within a fund.

However, the annual management charge is only part of the story and even the ‘total expense ratio’ (TER), i.e. the annual management charge plus administrative costs within the fund, still does not include all costs.

Clive Waller at CWC Research says ‘The AMC is a useless figure, the TER is misleading because it is not total – its does not include dealing charges or, if it is a fund of funds, the charges on the underlying funds. If the buyer knows exactly what the true cost is, he can compare fund manager performance against charges and make an informed decision’.

Hidden Trading Costs

Every time a fund manager carries out a trade (i.e. buys and sells a stock), various trading costs are incurred for the investors within the fund, e.g. stockbroker commissions.

The industry regulator, the Financial Services Authority (FSA), has estimated that the average cost of buying and selling a single stock within the UK large cap equity fund to be 1.8% of it’s value.

The hidden trading costs paid by investors therefore depend on the percentage of the stocks within the fund that are traded each year. We call this the ‘turnover rate’. A high turnover rate will mean high hidden trading costs within the fund and will act as a drag on investment performance.

Based on the FSA’s research, almost a quarter of equity funds have a turnover rate of 100% of their holdings in the course of the year. The average turnover of the UK equity fund is around 66%, i.e. two thirds of the stocks within the fund are traded each year in order to attempt to ‘beat the market’.

Taking the average turnover figure, this means that in addition to the charges that you are told about, there is a further hidden cost of 1.2% per annum.

One of the main reasons why we now recommend low cost, passively invested portfolios is that, not only are the published charges lower than their ‘actively managed’ equivalents, the ‘turnover rate’ and therefore the hidden transaction costs are also much lower.

Stripping out the cost of advice in order to compare on a like for like basis, the difference in total cost can be estimated as follows for a portfolio comprising entirely of ‘growth’ assets, i.e. stockmarket investments –

Typical ‘active’ Investments BRB Investment Process

Annual Management Charge 1% 0.74%
Administrative Expenses 0.2% 0.19%
Estimated Trading Costs 1.2% 0.36%(note 1)
Total  2.4% 1.17%

Note 1 – based on a conservative 20% turnover rate although the current turnover rate within our portfolios is much lower

What is the impact of these hidden trading costs?

Let us assume that £100,000 is invested over a ten year period and achieves a rate of return of 7% per annum before charges. Using the above assumptions for charges, the final figures would be as follows –

Amount Invested Typical ‘active’ Investments BRB Investment Process

£100,000 £156,700 £176,200

The difference in final values is a staggering £19,500 over the ten year period.

Can ‘active’ managers add sufficient value to overcome all charges and trading costs?

Active fund managers with high published charges and high hidden transaction costs will argue that it is the end result that counts and that their skill in stock selection can more than make up for any deductions that are made from the fund.

Our research indicates that the majority of actively managed funds do not beat the market and that the ‘winners’ do not tend to repeat. A major reason behind this underperformance is the level of deductions within the funds. We are convinced that there is no reliable and repeatable method of predicting the outperforming managers and therefore we do not try to do so.

Instead, we concentrate on the things that can be proven to matter the most, i.e. the way that we split your investment between different asset classes and keeping costs to a minimum.

We also ensure that you are never exposed to any more risk than you can tolerate and that you receive investment advice in the context of an overall financial plan designed to meet your objectives.

Should you have any queries regarding any aspect of this investment bulletin, please do not hesitate to contact your BRB adviser.