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IMA: Hidden costs – what hidden costs?

Here’s a new year puzzle for you. Fund A has annual charges of 1.5 per cent, and in addition incurs annual trading costs in its portfolio of 0.2 per cent. Fund B also has charges of 1.5 per cent a year, but its trading costs are 0.4 per cent a year. Which is better value for money?

There’s a group of people out there who want you to believe the answer is fund A – after all, the costs are lower, so you must get a better return.

Now here’s another clue. Last year fund A returned 1 per cent less than the stock market index, while fund B returned 1 per cent more. In other words the extra 0.2 per cent of trading costs resulted in a 2 per cent extra return. In my book that would be pretty good value for money.

These are illustrative examples. It would be wrong to argue that funds with higher trading costs always perform better. But the point is that they might. And you do not know unless you look. The costs of trading the portfolio are inseparable from the impact on returns of the associated investment decisions.

The combined effect of trading decisions and their costs is reflected in a fund’s net performance, which is measured after published charges, after trading costs, and after any other effects including the bid/offer spreads on underlying investments. There is no hiding place for the fund manager from the cold facts of net performance: if he is not delivering for investors, the fund slips down the performance tables and, in the absence of improvement, is likely to lose custom to its competitors.

2012 is seeing a renewal of the misguided campaign to include trading costs in fund charges. That campaign is misguided because it would mislead investors into thinking that trading costs matter in isolation from their impact on investment returns. It also ignores the iron discipline that net performance exerts on managers.

But, I hear you say, that still doesn’t tell us what all this is costing investors. All these extras – trading costs, bid/offer spreads, stamp duty and the rest – are surely leeching money out of investors’ returns, are they not?

The answer is, no they are not. How do I know? It’s the cold light of net performance again. When I blogged on this subject before Christmas, I pointed to research we did two years ago which showed clearly that the combined effect of investment decisions and trading costs was positive rather than negative for investors. We have now done some further analysis to take account of performance to the end of 2011.

And guess what? The result is the same. For both index trackers and active funds, the ten year performance showed no sign whatsoever of so-called “hidden costs” pulling down performance. For the record, FTSE all-share trackers returned an average 3.9 per cent a year, the difference of 0.8 per cent a year from the return on the index being exactly in line with average charges. And the active funds returned on average just over 4 per cent a year, or 0.6 per cent below the market – in fact recouping a significant amount of their typical charges of 1.5 per cent or so.

These are the facts. I’d like to think we will hear nothing more about “hidden costs” to investors, though I suspect I am going to be disappointed. But we at the IMA will aim at least to keep the debate informed with the true facts.

Richard Saunders is chief executive of the Investment Management Association


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There are 6 comments at the moment, we would love to hear your opinion too.

  1. Roger Chadbourne 30th January 2012 at 4:23 pm

    Haven’t you heard?
    “Past performance is not necessarily a guide to the future.”
    And anyone who says otherwise, especially in writing, is likely to be heavily fined, censured, struck off and have his first-born sold into slavery.

    Roll on retirement!

  2. Was this article written by the same person who invented absolute return funds!

    We all know about fund research and doing one’s due diligence – but frankly some fund managers are taking the Michael with what they expect a earn on the backs of customers and come RDR they are going to have to restructure their charging structure as the real value in any recommendation comes from the IFA and not the fund manager that largely tracks the performance of an index or the latest fad.

  3. What do these comparisons between a FTSE All tracker and the average Active Manager tell us on their own? Answer: hardly anything.

    Firstly, if the difference is so small, is it worth the chance that the active manager underperforms significantly as much as they perform well?

    Secondly, is the FTSE All Share on its own an ‘apple’ with which to compare the ‘orange’ of the invested markets within any sample of active managed funds?

    Fortunately for the bulk of the community of active fund managers, it will always be to most investors an enigma wrapped in a riddle shrouded in mystery and, like the alchemists of old, able to conjure any spin that contiues to serves its own interests.

  4. All we are requesting is that we are given the figures.

    Let us, with our clients, decide whether the extra cost is worth paying. How can we make this choice if they total charge the clients investment endures is hidden from us or at the very least so complicated to work out for every fund we recommend.

    Can you imagine the uproar if we advised a client that our charges for looking after his investments is quoted as £1000 or say 0.5% pa and then after a year the invoice is actually for £1,500 or 1.0% because our initial figure didn’t include certain business expenses. We would be closed down.

    Come on investment industry you must be gaining market share with the popular use of wraps, platforms etc never mind the life company fund links. Give us the information we need!!!

  5. Very few investor or consumers will discover the trading costs as they are only disclosed in a fund’s annual reports and accounts (not in the KFD or simplified prospectus) – the turnover rates / costs of funds should be clearly disclosed in the KIID.

    The IMA data seems to show turnover costs for a selected group of large funds for one year – it would be great to see this analysis for all funds (in all sectors) over longer time period.

    The IMA data does not indicate whether the performance of funds is correlated with different levels of turnover – they only show average data – do funds with low turnover add more value? Their data on index funds seems to indicate this might well be true. It is also what William Sharpe found.

    Vanguard research (attached below) from the US showed that every 1% increase in portfolio turnover there was a corresponding drop of 0.22% in alpha. (Note: they found that TERs have a much stronger correlation – every 1% increase destroys 0.78% alpha).

    It is unclear whether the performance data for active funds has been adjusted for survivorship bias – this can distort the data by 2% or more per annum.

    The active funds selected should be separated into those with FTSE100 or FTSE All share benchmarks (and all other benchmarks should be excluded) – otherwise the data is flawed. This might be why there are only 129 funds in the IMA data?

    It would be really good for the IMA to sponsor some independent analysis from academics into this area – that would build much more confidence than limited data from a trade body that represents the interest of fund managers (

    I completely agree with IMA that people need to save more for the long term. The best way is to build confidence, which is built on trust which means full and transparent disclosure of all costs and charges up front!!

  6. This article is misleading. The average return of all active funds will be the same as the average return of the passive funds IF YOU IGNORE COSTS, it is a mathematical certainty because the passive funds = the average index return and that only leaves the active funds and active investors, so by definition they must also average out at the same return assuming the index is made up of all monies and funds. Therefore the only difference on the average is the cost. Read any decent investment book by successful investors and you are likely to read this time and again as it is such a funamental point, the summary put out by the active fund management lobby is limited at best and where is the so called analysis? Can we please see it? But good to get the debate aired.

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