Comment 

Investors lose 6 per cent in hidden rip-off

Moira O'Neill

Investors lose 6 per cent in hidden rip-off

This week Labour leader Ed Miliband said he would introduce a new consumer bill to give the Financial Conduct Authority powers to stop "rip-off surcharges" by banks and pension companies.

But the real rip-off is not the obvious high costs and charges on products. It is the myth perpetuated by the industry that investors can achieve high returns on equity-based products.

One investor, Pete Comley who describes himself as "just a private investor with an inquisitive mind" has exposed this hidden scandal in his excellent and absorbing book, Monkey with a Pin.

Starting with the premise that the financial services industry sells to customers – expected returns from equities of at least 5 per cent a year - he illuminates how difficult it is to achieve those expected gains in practice.

He concludes that the picture does not look anything like that portrayed by the finance industry. Far from investing in the stock market resulting in gains of about 5 per cent a year (above inflation), he concludes that the average real investor is missing 6 per cent a year from this and so is likely to be looking at a net real loss of about 1 per cent per year no matter how they invest.

The 6 per cent loss is made up of several factors. Investors lose out because they buy and sell at the wrong time, pick the wrong stocks or funds or have poor investment strategies. They also lose due to the costs of investing.

One hidden element that leads to losses is 'survivorship bias' - whereby poorly performing stocks or funds are delisted and therefore not included in performance analysis.

Take the FTSE 100 index. Every quarter there is a reshuffle of the companies in the index. About three companies might typically leave and join each time. At each reshuffle, they alter the weighting to allow for changes in market capitalisation and to include the new companies. Mr Comley writes: "You have a system where you are perpetually measuring the increasing performance of the UK's fastest-growing companies only. Any company that has below-average performance will soon get relegated and stop dragging the index down and will be directly replaced by one that is growing."

His conclusion: not only does this set wrong expectations for you regarding what happens to individual share prices but it can also lead you to follow strategies like buy and hold, which may not perform quite as you expect.

 

Here is how Mr Comley calculates the missing 6 per cent.

Factors reducing investors returnsInvestors in shares directlyInvestors in funds directly
Skill/alpha of the investor-1.30%-2.20%
Skill/alpha of a fund managerna0.20%
Index error due to survivorship bias-1.00%-1.00%
Trading commissions-2.50%-0.10%
Stamp duty-0.50%-0.30%
Bid/offer spreads-0.70%-0.10%
Initial charge/distribution levyna-0.50%
Price impactna-0.10%
Total expense ratio (TER)na-1.70%
TOTAL-6.00%-5.80%

Source: www.monkeywithapin.com

 

Of course, his 6 per cent figure is based on a simplified summary. Different funds and different types of equity investments have different costs associated with them. For example, index-tracking funds and exchange traded funds have much lower TERs than 1.7 per cent. Also, for direct share holders, the trading commission figure of 2.5 per cent will be less if you trade larger amounts.

But the figures still make a mockery of the projection rates used by the financial services industry to estimate future growth on your pensions and investments. Millions of people are still receiving annual statements on their pensions using growth rates of 5 per cent, 7 per cent and 9 per cent to estimate what their future pension will be. The Financial Services Authority has said that it will consult on reducing these projection rates, but it needs to get going on this quickly.

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