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Price of performance

I have been told that investment in passive funds can be a great deal cheaper than active funds. However, there is so much terminology used to describe the charges that I am totally confused. What is the difference between the annual management charge and the total expense ratio? Does the total expense ratio actually describe the total costs applicable to a fund?

Let us start with the terminology. The annual management charge is the cost levied by the fund manager for running the fund. This ranges from 0.1 per cent in the case of some trackers to 1.75 per cent or more for certain active funds.

Funds also incur ongoing costs such as custodian, accounting and legal fees. The total expense ratio is the sum of both sets of charges. However, this is by no means the end of the story.

The TER takes no account of the cost of implementing transactions within the fund. These depend on the level of turnover of stocks within the fund and total costs incurred for each sale and acquisition.

In the FSA’s occasional paper on the cost of retail investments available at occpapers/OP06.pdf, the average cost of a deal in a UK fund has been estimated at 180 basis points (1.8 per cent to you and me).

Portfolio turnover rates describe the proportion of the fund that has been turned over due to sales and purchases in each accounting year. They are calculated according to a formula prescribed by the FSA.

The greater the level of sales and acquisitions, the higher the PTR. Busy funds cost more but supposedly this is because they are meant to deliver more. I will consider this further with you on another occasion.

It is now a requirement for PTRs to be published for UK unit trusts and Oeics within the simplified prospectus. You still have to hunt around for these figures as they are often quoted separately from other cost data. Links to the simplified prospectuses for many major providers have been collated at http://

Let us now turn to the question of actual cost comparisons between active and passive funds. If we take the UK all companies sector as an example, most actively managed funds have an AMC of 1.5 per cent. They also have other expenses declared of typically another 0.1 to 0.2 per cent a year. On average, the TER amounts to around 1.6 per cent a year.

Compare this with, say, Fidelity moneybuilder UK index tracker which has an AMC of 0.1 per cent and a total TER if 0.28 per cent.

Before even considering portfolio turnover costs, the average actively managed fund has to deliver a further 1.3 per cent or so each year, without taking any more risk than the index, in order to simply match a tracker. You then have to ask yourself two questions. Is it worth paying extra to simply keep up with the index? How likely is the active fund to equal or beat the index? I will deal with the second question on another occasion.

Moving on to the effect of portfolio turnover, if you take the average PTR of an active UK fund of 70 to 90 per cent (page 47 of the FSA paper), you end up with costs in addition to the TER of between 1.26 and 1.62 per cent. Some funds incur substantially greater costs than this. For example, the Fidelity special situations fund has a PTR of 137 per cent, leading to an overall portfolio turnover cost of 2.46 per cent. Quite a few active funds have PTRs of over 200 per cent, leading to turnover costs of 3.8 per cent in addition to the TER.

Contrast this with a typical tracker. The F&C FTSE All Share index tracker has a PTR of 0 per cent. Others have PTRs of between 10 and 20 per cent. To get the total annual cost, you have to add the PTR cost to the TER. This means that the actual annual cost of the average active UK fund amounts to between 2.86 and 3.22 per cent.

In the case of Fidelity special situations, you get total annual fund costs of 3.96 per cent. In contrast, the F&C FTSE All Share index tracker has combined costs of 0.39 per cent.

This means the average active fund has to outperform trackers by up to 2.94 per cent without taking any more risk.

Quite apart from wondering whether active funds can recover the extra costs and consistently achieve returns well in excess of them, you have to ask just how much cost an equity-based investment can put up with before the prospective returns on reasonable assumptions are reduced to a level no better than cash.

If this occurs, you will have incurred all the risk associated with equity-based investments but attracted none of the gains.

Chris Wicks is a director of N-Trust


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