Secrets Of Success: Investment costs still don't add up

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It has taken some time, but the message that costs matter when investing seems to be making some progress, if slowly, in the consumer arena.

One of the things that surprised me when I first started writing about funds in this space 10 years ago was how little attention was given, anywhere in the media, to the role that costs play in determining medium- and long-term returns for investors.

For years, long-term investors had endured the extraordinarily unfavourable pricing policies of the life companies. The real costs of owning long-term savings policies (some of which were quite remarkably high, and detrimental to savers' interests) were hidden behind a veil of confusion and obfuscation that was more or less impossible to penetrate.

Yet, even when the facts started to come out into the open, it seemed to have a minimal effect on the way that investors chose to behave - a trend that has also long been evident with the costs of unit trusts, OEICs and investment trusts.

The recent efforts made by the FSA to improve disclosure, and the calls for a new generation of cheap and cheerful funds made in the Sandler report, have by and large had minimal effect, with stakeholder pensions a flop - and the ill-fated CAT standard has been abandoned.

The latest annual survey of cost trends in the funds business, published this week by Lipper Fitzrovia, paints a helpful picture of an industry that is pulling in two different directions. The basic message of the survey is that, while the cost of index funds and other passively managed funds is starting to come down, the trend for actively managed funds is actually going the other way, heading upwards.

This has also been the experience in the United States. There, while you can buy an index fund at a very competitive cost these days (with total expense ratios as low as 0.1-0.2 per cent per annum, against an average of just under 1.0 per cent in this country), the average trend for actively managed funds has also tended to rise over the past 15 years.

This trend has been interrupted by the fallout from the Spitzer inquiry into the so-called "market timing" scandal in the US mutual fund business. As well as imposing fines, the settlement of these cases involved the firms being required to reduce their annual management fees to compensate longer-term investors for what had happened.

By one of those nice ironies that occasionally happen, this settlement seems to have had the effect of forcing other firms (including those that had no part in the scandal) to lower their fees in order to remain competitive with the worst offenders.

This is probably only a temporary effect. As with the investment banking scandal that Spitzer investigated earlier, when many of the grandest investment banks were slated for their role in using dud research to promote absurd internet companies they knew to be of little value, in the funds business memories seem to be surprisingly short.

The truth is that many fund investors still blindly buy what they are told to buy by their banks or financial advisers, with cost rarely featuring as a consideration. This is not entirely surprising, as one of the biggest elements of that cost is the bank's or adviser's commission for selling the fund (turkeys rarely vote for Christmas).

The trail commission, or annual renewal fee, that the distributor of a fund receives is typically 0.5 per cent per annum, or more than a third of the average overall management charge.

It is, of course, entirely logical that investors should be happy to pay higher charges for an exceptional fund, one that delivers consistently superior returns over a three- to five-year period, and to pay an adviser who points them to those funds for the help they get.

The problem here is that only a small minority of funds are capable of delivering that performance. While we do not know how good advisers are at picking the best funds, the aggregate sales figures suggest that there is a better correlation between sales and past performance than there is between sales and future performance.

The latest Lipper Fitzrovia figures suggest that what is happening is that, while larger and more successful funds are failing to pass on the economies of scale that come from growing in size, smaller and less successful funds are edging their fees up anyway "so as not be out of line with the competition".

None of this clearly suggests a market that is operating on the basis of price competition. With index funds, which are a commodity, there is no such excuse, which is why we should all be grateful that competition and disclosure are finally (but very slowly) driving costs down. Competition is coming mainly from the new breed of exchange-traded funds, whose average total expense ratios are about 0.5 per cent a year, comfortably below the 1 per cent per annum still the norm for most unit trust and OEIC tracker funds. (The cheapest UK trackers now have a TER of 0.3 per cent per annum).

The hedge funds phenomenon of the past five years has demonstrated that it is possible for fund managers with good records and strong marketing to drive a hard bargain. Recent academic studies suggest that the best hedge funds are extracting roughly half of any excess returns that they are able to achieve in fees.

The story from the bond fund world, meanwhile, is no more encouraging. True, annual management fees seem to be pretty flat at just under 1.1 per cent per annum. Some corporate bond funds have produced good returns as yields have fallen to remarkably low levels in the past two to three years. The broader issue here remains: why pay 1 per cent per annum for a fund that is virtually certain, at current yields, not to be able to return more than 4-5 per cent on any medium-term horizon? Cash is clearly a cheaper and better alternative for the moment.

jd@intelligent-investor.co.uk

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