We all know that the annual management charge quoted by funds is not the total cost. The total expense ratio, which includes “other administrative expenses” such as trustee fees, auditors, legal costs, printing etc, is often cited as the total cost – not surprising given the words total and expense. However the TER is not the total cost either. Far from it.
The costs incurred by the fund for any trading – buying and selling underlying investments within the fund – are not included in the TER.
The scale of these additional costs, let’s call them Portfolio Transaction Costs, varies enormously from one fund to another and can be more than double the TER in some cases.
Broadly defined, a fund’s transaction costs include fees associated with buying, selling and rebalancing the underlying securities, for example selling BP and buying Vodafone shares. They include:
Charges that a stockbroker collects for executing and clearing a trade. The actual cost will depend on volume, underlying security being traded and the market in which it is being traded.
2. Spread Costs
The bid / offer spread for a security and will depend on the relative size, trading volume and market in which that the security is quoted. Large capitalisation stocks typically have narrower spreads than smaller companies; US Equities narrower spreads than emerging market stocks, for example.
In some markets, for example, the UK, there is stamp duty or other taxes associated with trading.
4. Market Impact Costs
Market impact costs are incurred when the price of a security changes as a result of the effort to purchase or sell the security. There can be a bigger impact for larger funds (as individual holdings are larger) or in funds where the underlying investments are relatively illiquid.
5. Opportunity Costs
The cost of missed or delayed trades. The longer it takes to complete a trade, the greater the likelihood that someone else will decide to buy (or sell) the security and, by doing so, drive up (or down) the price. The larger the trade / smaller the average daily trading volume the longer the trade will take to complete.
It is difficult to accurately determine the total costs but there is a useful measure (tucked away in the fund prospectus) that can be used as a guide. The Portfolio Turnover Rate (PTR) is calculated by every fund and shows as a percentage the total proportion of fund assets that are traded in the previous year.
The FSA estimated in 2003 that 100 per cent fund turnover in a year would cost the fund between 1.5 per cent and 1.8 per cent, including stamp duty, for UK Equities. Fixed interest spreads tend to be much lower and are not subject to stamp duty in the UK.
Financial Express Data has calculated the average PTR for UK Equity funds at 95 per cent for the year ending February 2009. So using the FSA cost figures this would equate to an average additional PTC for UK Equity funds of 1.56 per cent above the TER.
In some markets these transactions costs have been calculated to exceed 9 per cent.
Why is this important? Well a fund with 1.5 per cent p.a. lower total costs will be 30 per cent larger in 20 years assuming a growth rate of 7 per cent p.a before costs.
It is also important to understand what the end to end costs for investors are. With a wrap at say 0.3 per cent, platform rebalance fees of 0.2 per cent, TER of 1.7 per cent and PTCs of 1.5 per cent the end investor is paying nearly 4 per cent p.a. for equity exposure – that is some performance hurdle to achieve breakeven! And with fund of funds the hurdle is even larger.
Each fund sector displays a wide range of PTRs some below 20 per cent and some over 500 per cent – that would imply stamp duty costs of 2.5 per cent p.a. alone for a UK equity fund.
Passive funds and exchange traded funds by their very nature have much lower PTRs than active funds. And this is a key driver behind the move towards passive funds, as not only are their typical TERs much lower, but so too the associated trading costs. For long term investors the impact of charges is a key driver of returns, perhaps the most important after asset allocation.
This is not to say that active funds cannot outperform, but a key risk is the existence of any costs that must be exceeded before the investor benefits. Advisers should be aware how high the manager’s performance hurdle is before they commit funds and ensure that each manager is able to convincingly explain how these hurdles will be beaten.
An adviser who is able to locate funds with lower overall costs / charges and is thus able to deliver an increase the fortunes of their clients on a sustainable basis should sensibly be rewarded for this.
Einstein described compound interest as the eighth wonder of the world – better to have it on your side with low cost rather than against you with high charges.
David Norman is former chief executive officer of Credit Suisse Asset Management UK.