When it comes to fund performance, costs matter. Yet cost disclosure in the funds industry remains a highly contentious issue. As calls mount for greater transparency of fund charging structures, we look at ways investors can minimise the costs of investing.
Research by funds data provider Morningstar has shown fund expense ratios as strong predictors of performance. In a study of US funds, it found that in every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile. A study by TCF Investments (Low cost funds outperform) has similarly highlighted fund fees as a predictor of future returns, while a recent survey for FTMoney found that 80 per cent of investors thought fund charges were opaque.
So, if fees matter, the obvious answer for investors would be to pick cheap funds. Unfortunately, it is not that simple. A lack of transparency in showing what charges are along with lack of consistency in how charges are calculated makes straightforward comparison between funds difficult.
While a fund's total expense ratio (TER) tends to be a much better indication of a fund's cost than the annual management charge provided on the fund provider's fact sheet, even this metric is far from a total reflection of what a fund costs. As a start, the TER does not include trading costs.
Campaigning for transparency
A number of players in the funds industry are pressing for greater transparency when it comes to fund charges. Following a decision in September last year to show fund manager, adviser and platform charges on its platform separately, fund supermarket Fidelity FundsNetwork wants the asset management industry to develop a standard approach to disclosing the total cost of owning a fund.
"Some companies are only presenting part of the picture and, crucially, they are failing to show the cost of advice or the cost of the platform, without which investors would not be able to access the fund," says Gary Shaughnessy, UK managing director at Fidelity Worldwide Investment. "Others have very high minimum investments and are only available to high-net-worth individuals. What will really help investors is a transparent and standardised cost breakdown in pounds and pence."
Fidelity has set out an example of all the costs of owning a fund on its platform (see table below). At present, most fund literature does not set out all of these.
Fidelity example of what charges funds should show
| Charge | Typical amount for an actively-managed fund, expressed in % and £ for £10,000 investment | Typical amount for a low-cost active fund, expressed in % and £ for £10,000 investment | Typical amount for an index tracker fund, expressed in % and £ for £10,000 investment |
| Investment management charge | 0.75% (£75 a year or £6.25 a month) retained by fund manager | 0.40% (£40 a year or £3.33 a month) | 0.1% (£10 a year or 83p a month) |
| Other service and administration charges (eg legal and custody) | 0.14% (£14 a year or £1.17 a month) passed on to service providers | 0.2% (£20 a year or £1.67 a month) | 0.2% (£20 a year or £1.67 a month) |
| Cost of advice or distribution | 0.5% (£50 a year or £4.17 a month) | 0.5% (£50 a year or £4.17 a month) | Nil (for Moneybuilder UK Index but advice or distribution charges may apply in other cases and are often excluded from illustrations) |
| Platform administration charge | 0.25% (£25 a year or £2.08 a month) | 0.10% (£10 a year or 83p a month) | Nil (for Moneybuilder UK Index but platform charges may apply in other cases and are often excluded from illustrations |
| Stock Market dealing costs and Government stamp duty | 0.36% (£36 a year or £3 a month) | 0.25% (£25 a year or £2.08 a month) | 0.09% (£9 a year or 75p a month) |
| TOTAL ANNUAL COST OF OWNING A FUND (based on investment of £10,000) | 2.00% (£200 per year or £16.67 a month) | 1.45% (£145 a year or £12.08 a month) | 0.39% (£39 a year or £3.25 a month) |
Source: Fidelity as at 27/01/2012
Wealth manager SCM Private has also called for greater transparency over charges, launching its True and Fair Code and Labelling Scheme, a campaign for change. Key issues SCM is looking to address include the multiplicity of hidden fees, lack of product transparency and the convoluted language the investment management industry uses – all making it difficult for consumers to make informed and competitive investment decisions.
SCM is also calling for standardised labelling, which would enable investors to compare one investment product with another on a like-for-like basis, whether it be a pension, unit trust, investment trust or exchange-traded fund (ETF).
"Ask yourself how much profit Tesco made last year and you will be told one number, but ask how much an investment costs and you will be told five to 10 different numbers, some in pounds and some in percentages," says Gina Miller, founding partner of SCM Private. "This explains why consumers simply do not understand how much their investment is costing them. People should know this before, not after, they hand their money over.
"Most of the information we are calling on investment companies to display is already available, but consumers have to play hide-and-seek among a myriad of documents to find it."
Portfolio turnover rate
One of the largest 'hidden' factors are fund dealing costs. These are not stated in the TER, but if you delve into a fund's annual report or documentation, you can obtain what is referred to as the portfolio turnover rate (PTR).
If you already own the fund you will be sent the annual report, which usually contains this figure. If not, data provider Morningstar has electronic versions of these reports in the documents section of its pages dedicated to a fund, available at www.morningstar.co.uk
But the PTR is limited in itself as it does not state the price of the dealing costs. Rather this figure is a percentage that indicates how often the fund is trading assets. The higher the PTR percentage, the higher the trading costs, but, ultimately, unless you are an analyst and familiar with fund accounts it may not mean much.
The PTR also has to be looked at in context: different types of funds trade more than others, so you should compare funds in the same sector. But, even within a fund sector, different styles of fund management and market circumstances could necessitate higher levels of trading.
As of June this year, fund providers will no longer be required to give a fund's PTR figure. Despite the obscurity of this metric, investment professionals argue that this is a step back in transparency.
"Even if everyone can't understand it, this is not a reason to scrap the PTR," says Ed Moisson, head of UK research at fund research company Lipper. "If UK investors do not understand it, they can go to an adviser who does. It is not perfect, but it is a reasonable guide."
"The loss of the PTR in its present guise is not entirely bad," argues Christopher Traulsen, director of fund research for Morningstar. "Turnover using a better measure would serve as a useful rough guide for investors as to the potential trading costs incurred by their fund. But doing away with the PTR requirement in its entirety marks a step backwards in transparency. A PTR using a simpler calculation would be a step in the right direction."
Tom Stevenson, investment director at Fidelity, also wants to continue to see some kind of detail on transaction costs in fund documentation. "But we want one that is more meaningful than the PTR," he says.
The costs of trading
Accusations of 'hidden' charges have led the trade body for the UK's £4 trillion asset management industry, the Investment Management Association (IMA), to analyse how trading costs impact investors' returns. These costs are incurred as a result of the manager making investment decisions in accordance with a fund's investment objectives and strategy.
Using fund literature, the IMA analysed the fund accounts of a number of large UK All Companies funds in 2009. The IMA found that the transaction costs of actively managed funds were 0.31 per cent of average assets, of which two-thirds was accounted for by stamp duty. In tracker funds, transaction costs totalled 0.06 per cent.
The IMA argues that these transaction costs are very small for index tracking funds and are, on average, more than offset by investment returns in the case of active funds. This is confirmed by IMA's latest analysis, which compares the average net return of 129 active and passive funds in the UK All Companies sector with that of two benchmark indices, the FTSE 100 and the FTSE All-Share.
The IMA compared the annual difference over the 10-year period to December 2011 between the return on the benchmark and what the investor would have received after charges. It found that for the tracker funds, the TER was broadly the same on average as the difference between the benchmark return and the fund return, while for the actively managed funds, the difference between the net fund return and the benchmark return was on average significantly less than the TER, confirming that the transaction costs were more than covered by the investment returns from active management.
Annual difference over the 10-year period to December 2011 between the return on the benchmark and what the investor would have received after charges
| Annualised fund return (income reinvested) (%) | Annualised Benchmark return (income reinvested) (%) | Annual difference (%) | Average TER (%) | |
| FTSE 100 trackers 10 years | 3.27 | 4.2 | -0.89 | 0.84 |
| FTSE All-Share trackers 10 years | 3.87 | 4.69 | -0.79 | 0.8 |
| Active funds 10 years | 4.04 | 4.69 | -0.63 | 1.56 |
Source: IMA
"While transaction costs can only be implied from this data, there is nothing to suggest that they are significantly hampering fund performance," says the IMA.
But Nick Blake, head of retail tracker fund provider Vanguard, begs to differ. He says discussions around average performance can be unhelpful as investors rarely experience the average. "The one discernible investing factor known at the outset is that costs matter. Simple arithmetic demonstrates that an investor paying a total cost to invest of 2 per cent will have lost 40 per cent of their portfolio return over 25 years. Traditional investment marketing suggests this price is worth paying for the outperformance earned. Looking at the actual data confirms this isn't the case," says Mr Blake.
Adrian Lowcock, senior investment adviser at Bestinvest, agrees: "Charges do have an impact on performance. And, until investors understand what is being charged, they can't decide if a fund is good value for money."
Do you think portfolio turnover rates are unclear? Should they be scrapped or what alternative would you suggest? Email leonora.walters@ft.com, or comment below.
