mindmoneymarkets

What the crash says about the UK pension apartheid

For me, the recent market shakeup has highlighted the growing pension apartheid in this country. There is a clear division between…

1)      The pension haves (final salary pensions usually public sector) and

2)      The have nots (everyone else on defined benefit/ personal pension).

I won’t go into the politics of it all here, but following the recent turmoil, George Osbourne might find he is in a stronger negotiating position going into the next round of public sector pension negotiations.

As companies and governments close off their final salary schemes, there will be more people shunted onto defined contribution type plans which depend not on the number of years of your service/ final salary, but on the performance of your investments in the long run.

There are many problems with this:

Low Cost Investing In the UK

Compared to the US, low cost investing in the UK is a bit of a misnomer, but we still have to make the most of a bad situation. A recent article in the FT (Behind the paywall sorry) highlighted this problem sharing Morningstar’s Global Investor Experience study which found that the US was one of two countries to score an A, while the UK scored a poor C+.

There was a great post from Mebane Faber showing four cheap portfolios without commissions for US investors.

The portfolio is nicely balanced with:

• 40% domestic equity (US)
  • 25% broad market
  • 10% small cap
  • 5% Real Estate
• 20% international equity.
  • 10% broad international
  • 5% international small cap
  • 5% emerging markets
• 40% fixed income.
  • 30% investment grade or T bonds
  • 10% Inflation linked

The total expense ratios were between 0.13% and 0.27% all had free trading/ switching mostly online only.

Can this be done in the UK?

For my own personal investing and potentially for the interest of other UK investors, I thought it would be a worthwhile exercise to try to replicate a similar portfolio based on the options available here.

The low cost nature of the portfolio is obviously appealing, but there may also be the added benefit of lower fee funds out performing.

In the UK, the only way to do this at present would be via a fund supermarket such as that offered by cofunds, Skandia, Fidelity & hagreaves Landsdown. The annoying thing is that most of these market to advisors rather than opening the platform up directly to consumers. I’m not sure how this will change with the introduction of RDR (Banning of sales commission on funds), the situation is complex with some believing that the fund supermarkets are actually responsible for driving fees higher.

The alternative to a funds super market is to use a self invested ISA or Pension to choose ETFs. The trouble is that fund supermarkets that allow free dealing/ switching, but in a share ISA that allows ETFs,  any investments/ top ups/ rebalancing in ETFs will incur dealing charges each time.

As the FT recently noted, the UK is indeed in dire need of its own John Bogle.

That’s enough moaning, let’s see what we can do with the resources available to us in the UK. My first criteria is that it is tax efficient (Pension or Isa wrapper).

Fidelity

I’m going to start with the Fidelity stocks & shares ISA because it has a very useful fund evaluator.

I used the tool to search for funds with a maximum TER (Total Expense Ratio) of 0.5% with no standard initial charges or exit charges.

This cut 1,200 funds down to just 13!

I then honed in on the funds with the smallest tracking error picked the ones with the smallest fees if multiple funds covered the same sector.

• 40% domestic equity
  • 25% HSBC FTSE all share index retail.
  • 15% HSBC FTSE 250 Index retail.
• 20% international equity.
  • 10% Schroder QEUP Core US.
  • 5% HSBC Pacific Index ex Japan.
  • 5% HSBC Europe Ex UK.
• 40% fixed income.
  • 30% HSBC UK gilt index
  • 10% Legal & General Index linked gilt

Average expense ratio of 0.28%

So not bad, but it’s not quite there. There were no small cap (domestic or international) with low enough fees and no real estate fund. The Pacific ex Japan was also the closest I could get to an emerging markets fund.

In a follow up post I’ll look at what can be found from a different fund super market or through a SIPP/ ISA taking into account annual rebalancing fees.

Please don’t take this as investment advice and all that…

 

Always read the small print...

Hi and Merry Christmas & Happy New year to one and all.

Thanks for reading this blog over the past year. I’ve enjoyed sharing my research over the last year and I’m pleased to be back in the hot seat now my move back to the UK is finally bedded in.

The New Year is a time for reflection on the year’s successes and mistakes. I feel I learn best from my mistakes, especially when I readily admit to them rather than trying to self justify.

I won’t bore you with the details of my first mistake. This was to chose Virgin Media as my internet provider. It took 8 weeks and multiple calls to their call centre to finally get set up only to find the connection not even at dial up speed. I’m there now, but if your work depends on an internet connection being set up promptly then I would seriously think twice before signing up with Virgin Media.

Ok on to my main mistake of the year (actually from past years, but my fault for not checking it sooner).

Always read the small print with investments.

A few years ago I belatedly set up my personal pension. This was before I’d done so much serious in depth research into the impact of trading & investment costs. I wish I knew then what I know now.

I knew enough to keep costs low. I chose a well balanced portfolio of funds with the average annual management fee being 1%. This is actually relatively high compared to other options available, but they were certainly the lowest fees on offer amongst the various funds presented to be by the Independent Financial Advisor. I could have easily gone for funds with annual fees of 2% or higher. I also made sure that there were no initial investment fees in the funds themselves. What I didn’t check was the small print regarding management fees.

Following this excellent article in the Telegraph on high fees UK investors are paying compared to other countries such as The Netherlands, I decided to take another look at my pension.

Here’s a choice quote:

“If a typical Dutch and a typical British person save the same amount for their pension, the Dutch person can expect a 50pc higher income in retirement.”

Why is that? Are the Dutch and the Danes better investors? No, they simply pay lower fees, which have less of a negative compounding effect on your investments.

The original study was commissioned by the RSA with warning comments about the cost of ignorance on costs such as: “When people hear that they are being charged 1 per cent or 3 per cent, they think they are being charged 3p in the pound or 1p in the pound, and think 'that's fine'. But because of compounding, the pension costs actually add up to 40 per cent"

Warning bells

I had a vague memory about exit penalties from the pension if a decide to come out of it early or switch. However I had never paid much attention to how this was actually structured.

My mouth nearly hit the floor when I clarified this recently.

The pension charges me 5% PA on top of the Annual Management fees for the first few years then it reverts to no extra fee and rebates me by 0.4% for the remainder of the pension.

In other words, for the first few years of my pension I have to pay 6% PA in fees for the privilege of getting fees of 0.6% for the rest of my time.

Although they are in the documentation, these fees were certainly not explained to me in these terms by the advisor. Put another way, it would take me 21 years for the benefits of the 0.4% rebate to start beating a set 1% every year.

The exit penalty is a fixed £362 to boot and I have three years of paying 6% before the rebate starts to kick in. I have three years of paying 6% left.

What to do?

There are various pension fund providers in the UK that provide rebates such as http://www.cavendishonline.co.uk/  allowing you to pick up fees in region of 0.6% straight off the bat. The January edition of Which? Magazine also had a great table showing the various providers and the discounts they provide.

The other option is a SIPP provided the set up costs are low. http://www.sippdeal.co.uk/ look a likely option. The disadvantage with a SIPP is that it is designed around individual purchases not regular investments so I would not be able to make regular contributions each month as the transactions fees would be prohibitive. Instead I would have to make annual purchases and pay fixed dealing costs.

The advantage is that a SIPP opens up low cost ETFs and Vanguard funds we fees in the region of 0.2 to 0.4%.

It immediately became apparent that the decision to switch out is a no brainer.

Say I have £10,000 in my pension pot. 6% of that is £600 lost in fees to my current provider every year for the next three years.

If I switch to another provider and pay 0.6% for that year, then it would be £420 lost in fees and charges, £180 better than keeping with the current provider. I’m up in year one with money back to me over the following two years.

However, if I can find a suitable SIPP provider, I may be able to push annual fees down to 0.3% and by making annual purchases I can keep transaction costs to a minimum.

This could make a dramatic difference over the life of my pension.

I would be £7,000 better off on a £10,000 pension switching to a provider giving me fees of 0.6% from day 1 compared to my existing provider. This assumes 5% growth P.A. and contributions rise with inflation. However, the advantage of paying 0.3% per year and a fixed £60 in fees is huge.  Switching to such an arrangement would be worth an extra £40,000 over my current provider.

Aside from the potential for extremely low fees through a SIPP, I like the possibility of accessing ETFs and trackers which I expect to have low hidden fees.

Hidden fees reduce costs even further.

Terry Smith explains more

“There is a justified focus on the Total Expense Ratio (“TER”) of funds which include those expenses which the manager charges to the fund rather than simply on the fund management fee. However, there is one major cost that is not charged to the funds-the cost of dealing in the underlying investments.

This is not insignificant given that, according to FSA research, the average fund manager in the UK turns over their fund 80% per annum. This adds three layers of additional costs: 1. The commissions charged by brokers and investment banks for dealing; 2. The difference between the bid-offer spread for securities sold and bought; and 3. The fact that no fund manager has sufficient good investment ideas to warrant buying and selling 80% of your investment portfolio per annum.”

These costs are generally felt via under performance rather than management fees. I’ve been checking a few ETFS and they seem to underperform the benchmark by a margin that is in proportion to the management fees as expected, but I shall be triple checking this.

Don’t be fooled like I was.

I hope my sharing of this mistake is of use to you. I know the pension systems are different across the world, but from my experience, it does seem that the UK system is highly skewed against investors.

This will become ever more apparent in the coming years as more companies shut down final salary schemes and even the public sector may follow suit if desperate. From 2012 financial advisors will be banned from taking commission on investments which I think will alleviate some of the problems, but not all of them. They will still receive ‘trail’ commission from investments made before 2013.

Of course, this is not financial advice. I hope by sharing my frustrations, it sparks your own investigations.

More musings to come…

Further Reading:

http://www.thersa.org/about-us/media/press-releases/going-dutch-how-to-double-the-value-of-british-pensions

http://www.independent.co.uk/money/pensions/revealed-the-scandal-of-how-pension-providers-rake-in-the-money-2157940.html

 

 

The real cost of Investing

There's a great series of articles in the UK's Telegraph at the moment focusing on the hidden fees UK investors wind up paying with their investments. The Telegraph did a good number on politicians expenses, so I hope we get similar mileage with this series. Somehow I doubt it, the politicians didn't make up a large chunk of the paper's advertising revenue.

I've touched on this in the past here and in this series of posts. 

The upshot of the articles is that investors in the UK pay much but in fees than other countries such as the US. Often these fees are hidden, meaning investors have no idea how much they are losing out.

Why does all this matter?

Very few companies offer final salary pensions whereby you are guaranteed a % of your salary as an annuity on retirement. Nowadays, they offer various schemes which involve the individual contributing to a company pension plan which has no guarantee of final earnings. Many companies match or even double an individual's contribution which is great, the dangerous part is the pension scheme itself. UK investors may not have much of a choice in the company scheme, often funneled into plans that have high charges and hidden fees.

Again, the Telegraph has a good summary of the problem and how we got to the current status quo.

As I've written about previously, the difference in paying 1.5% in annual fees vs 0.5% is massive in the long run, especially with the evidence in favour of higher fee managed funds being mixed at best.

Now, more than ever the onus is on the individual to do their own research and be fully aware of the implications.

Caveat Emptor and all that.

Advisors:

"Alan Miller of SCM, one of the City’s most successful fund managers, said: “There are insidious relationships across these different parts of the industry. Advisers will never recommend the cheapest funds because they don’t pay commission.” "

It will be interesting to see if things change when the commission ban comes in in 2012. 

Another area of ripe for exploitation is the client side fund managers such as those in change of managing local government pensions.

"Those in charge of deciding how to invest institutional and company pensions also mingle with executives keen to get control of their money. Representatives from huge fund groups – including Goldman Sachs and Schroders – paid £1,670 each to meet managers of some of the biggest local authority pensions at last year’s local government pension fund symposium."

This sort of thing has been happening for donkeys years, its how many businesses work. You build relationships with clients and give them an all round good time in the hope that they swing some business your way.

I've no problem with that per se, the problem comes when these relationships lead to deals that are not in the best interests of the fund's customers AND to make matters worse, these favours can end up being passed on to investors in the form of hidden fees.

Hidden Fees

"Brokers make money by charging commission on the trades. Investors would hope that the broker chosen by their fund manager would be the one offering the best improvement on the price being quoted by a stock exchange.

However City insiders said this is not always the case. One trader said: “I know some people who only use one broker. Some just use their best mates, some are receiving nice presents. People are human.""

The problem wouldn't be so bad if there was any transparency about these fees. They are often absorbed into the performance of the fund, making it hard to get an estimate of how much these extra transaction costs will hit your bottom line.

The Telegraph estimates these transaction costs can add another 1% in fees each year. 

Total Expense Ratio Vs Annual Management Charge

From the Telegraph once again:

Under strict Securities and Exchange Committee rules, US firms advertise the “expense ratio” as the headline figure to would-be investors. In Britain, however, companies are allowed to separate the smaller “annual management charge” (AMC), which is typically used in marketing.

HSBC last week advised a Telegraph reporter to take out their World Selection pension, currently ranked the costliest by the Financial Services Authority. Its adviser only talked about the 1.25 per cent AMC. For a 25 year-old saving £200 a month for the next 40 years, this alone would cost £137,445. At a London branch the reporter, who twice stated he was new to investment, was told: “This is an annual management charge of 1.25 per cent, OK?”

Further inspection of fund literature showed the fund’s Total Expense Ratio was two per cent.

Today I phoned up Fidelity and Clerical Medical to get an estimate of the annual cost that trading and transaction costs incur. They couldn't tell me.

I am still therefore unsure as to whether the so called Total Expense Ratio actually includes all the costs after all.

It appears not and sadly I can get no accurate estimate of this cost.

"The AMC is a quite useless figure; the TER is misleading because it is not total – it does not include dealing charges or, if it's a fund of funds, the charges on the underlying funds," says Mr Waller. "If the buyer knows exactly what the true cost is, he can compare fund manager performance against charges and make an informed decision."

I accept it will vary each year, but neither Fidelity or Clerical Medical could tell what the cost was last year. Fidelity advised me to view each fund company's annual performance and work out the costs from there.

How the hell is this right? How is Joe Bloggs working down the bread factory going to be a) able b) motivated to get this information. 

Transparency is clearly lacking as the Telegraph point out:

"Mr Stevenson says: "Simplistic comparisons between the charges levied on actively managed funds and index-tracking or passive funds miss the point. The two investment approaches incur different levels of cost, so the question is not whether stock-picking funds should be more expensive than trackers (they are) but whether their higher charges are transparent and a fair reflection of the extra resources and effort involved.""

Conflict of interest

The Telegraph have done a great job with these series of articles, but ruin it with one paragraph which is a clear compromise for the active fund management industry which advertise heavily within its pages.

Here's the quote:

The fund groups that charge the most argue that investors are better off paying extra for decent performance. However, a significant number of funds fail to deliver consistent above-average performance year in, year out, and if you are paying a high TER for dismal performance it is time for a rethink.

Ok, completely agree, then we get this kicker.....

It is clearly worth paying a higher TER for consistent outperformance and a high TER does sometimes pay. Take Jupiter Merlin Balanced Portfolio. This popular selling fund has a TER of 2.3 per cent, which is higher than the average – yet it outperforms its peers regularly and is justifiably recommended by many investment advisers.

Let's take a look at that fund:

TER: 2.3%
Initial charge: 5.25%
TER Including hidden fees? Unknown. Potentially as much as 2.75%.

Edit - I made some changes to my original post due to mis-interpreting Morning star's performance figures. General conclusions are the same but less pronounced. My original post went back about 5 years, this data goes back 8 years so results are again slightly different.

Going back to 2003, excluding any fees, the fund would have turned £10,000 into £21,227.05. Sterling stuff, with the benchmark returning £16,330.0

However, if we include the worst case fees scenario (TER of 2.75%). The return is just £16,091, vs the bench mark return of £15,375.67 (Cost of 0.75% TER assumed).

That's over £5,000 in profits pocketed by the fund management firm in 8 years. Including these fees, the managed fund out performs the benchmark by just £700.00.

Still out performance, but there was only one losing year for the bench mark and the managed fund flunked it big time. How would the long term performance stack up if we were able to go back prior to 2003?

Ok so the fund outperforms the benchmark (just), but this is being held up as a shining light example of a fund that consistently out performs. What about the myriad of other funds that did not beat their bench mark? Would investors have had the clear foresight to pile their money into this fund all those years ago?

Perhaps they might have waited for 3-4 years of live performance before investing. In those first 3-4 years, the fund did very well. However, had you invested in the fund after year 4, your £10,000 would be worth £9256 in year 8 vs the benchmark £10,765

Wrap up

After fees, the real take home returns for UK investors is going to be significantly lower than benchmark returns in the region of 8%. This must be taken into account when performing retirement calculations.

Even if you have time to do the research, you cannot get the full facts.

Therefore, in my opinion, it is better to reduce known costs and just hope that these hidden costs are not too exorbitant. One way to control this is to stick to trackers which in theory should have lower turnover and lower transaction costs.

This is not investment advice, I'm just trying to steer through the murky waters.

It certainly makes one question whether equities are worth it in real terms. Though alternatives such as collecting are not exactly liquid, you might get some enjoyment out of it along the way. Then again you may wish to invest and feel good about it. 

I'll be sticking with equities, but keeping costs low and diversifying further away from just financial markets once I've got some major expenses out of the way (Wedding & house). 

I do not doubt there are some very talented fund managers out there, indeed the Merlin Balanced did very well before fees. The problem is that at the investor end, you have to find a fund that performs very well after fees and for that fund to maintain the performance over not just 5 but 10,15,20 years. No mean feat. A fund that charges 3% a year including hidden charges has to beat the benchmark by more than this margin to justify these fees. 

Costs are very very important, but so is performance and tracking error. There's no point buying a cheap managed fund if it will perform even worse than the bench mark. The benefit of trackers is that they offer a cheap way to track a benchmark, yet some of these even charge 1.5% with a load fee.

Are you a speculator or investor?

ah back in the blogging saddle after a few weeks worth of heavy work to wade through.

Some interesting posts to investigate, especially the work on the Trend Strength Indicator. I've penciled in some analysis comparing the uses/ benefits of this compared to the TVA. http://cssanalytics.wordpress.com/2010/06/29/trend-strength-index-tsi-results-summary/

Another interesting post from CXO. From my experience I'd agree entirely with these findings, but would be interesting to see a similar study over a different time frame. The study found that those brokerage clients stating they were doing it for "speculation" dramatically underperformed those in it for capital growth.

http://www.cxoadvisory.com/individual-investing/individual-investor-performance-by-motive-and-method/

Post 2000 wasn't exactly kind to speculators! However, I think the same study in different markets/ time frames would throw up similar is less pronounced results.

Certain mirrors performance in my own trading/ investment journey anyway as I change my outlook.

Active vs passive funds

If you haven't seen it, there's a nice argument building on FTfm (Financial Times Fund Management) about the merits of Active vs Passive investing.

I was particularly intrigued given the new UK coalition governments proposals to increase capital gains taxes on shares to 40% and perhaps 50%. The is a backlash against this, so the plans may be watered down when they come out. Any increase in fees will no doubt push more money into tax efficient vehicles such as ISAs or pensions so the choice of what to do within those wrappers becomes ever more important.

Short term/ active trading is one thing -  What I'm talking about here is the supposedly safer, more longer term means by which we save for our future/ retirement. I've covered a few points on this here.

The argument over active vs passive investing will continue for years I'm sure. Naturally there's an element of both sides talking their own book, but I come down on the side of team passive investment. 

Trackers are more volatile .....

One thing that gets my goat is misinformation. I can't find the original link but I read an article in the Telegraph proclaiming that many financial advisers would be sticking to actively managed funds because they were less volatile. This article from the FT came with this quote which is just unreal: "

“One could argue that [passive] exchange traded funds are only suitable for investors who can sustain a 50 per cent loss in a year, given the fact that in the last decade the S&P 500 has suffered two severe drops, one of 46 per cent and the other of 56 per cent.

“One of the most basic things people expect from an investment adviser is that when the market heads south, someone will step in to protect them and help them to recover. ETFs, however, can never meet this expectation.”

Nonsense, he's comparing apples with bananas

A) Who in their right mind is exposed 100% to a single market for their long term investments? There's tons of free ideas out there on how the lay person (I firmly include myself in this) can diversify their long term investments such as investing 60% in stocks and 40% in bonds. The strategy historically performed as well as the stock market alone but with dramatically reduced volatility. With the use of index trackers you could do this with a cost of 0.5% a year or lower compared to a 5% load fee and 1%+ annual management fees from most managed funds.

B) The comment implies investment advisors are superior market timers....Really?

Here's some choice findings that dispute this from the same FT article.

"Yet the figures do not seem to bear this out. The monthly annualised standard deviation, a measure of volatility, of the UK’s FTSE All Share Index was 19.2 per cent during the three years to April 2010.

Yet the average actively managed fund in the UK’s All Companies sector had a standard deviation of 20.9 per cent, ie was more volatile, according to calculations based on Morningstar data."

Alan Miller, partner at SCM Private, a UK wealth manager that constructs portfolios purely of passive ETFs, labels the claims that passive funds are higher risk as “utter nonsense”.

“You are always going to have a more concentrated portfolio in an active fund, and with a more concentrated portfolio you would expect to have higher volatility,” he says.

“When one combines this with the fact that the average UK active fund typically underperforms the market by 1.3 per cent per annum [the average during the five years to February 2010], one can see that most active funds combine more risk with lower return.”

Nowadays individual investors can play the active manager with their own timing models. There is a fair body of evidence to support the idea that momentum models can at least provide superior risk adjusted returns.

Heck these may not play out as they have done in the past, but I'd rather make those mistakes myself as I'm doing with my own rotation portfolio than pay someone 5% upfront for the privilege of making the same mistakes.

The other side of the coin.

In defense of active management, I'm sure there are some genuinely hard working, talented professionals out perform thanks to skill. Something that doesn't make sense is the body of research on the success of simple diversification portfolios and rotation models vs the under performance of actively managed funds.

Do any funds apply these simple diversification or rotation models, or are they deemed to simple? Perhaps they are used, but only work with the benefit of hindsight? Perhaps so, but then we get back to the issue of risk. Where do the risks lie with passive/ index investing vs active management investing?

For me it comes down to this - Irrespective of whether you buy and hold with diversification or rebalance based on momentum, for the average investor you have a choice. With passive funds you're guaranteed to not out perform the benchmark, but in compensation you'll pay lower annual fees. With active funds, there is no guarantee you'll even track the benchmark let alone beat it. However you are guaranteed to pay more each year in fees which can eat up to 25-30% of your gains in the long run.

As a risk/ reward pay off in these terms, passive investing makes sense to me.

Further reading:

• Fund charges exposed as fees outstrip returns. 
• Tracker funds take a tumble. 
• Don't tar all actives with the same brush
• Data subverts attack on index trackers.
• Twisting the facts on active management.
• Active managers - Skillful, lucky or useless?

The real cost of trading part II

My previous post showed the results from trading a system with a very small edge. It revealed that if the differential between your average winner and your average loser is small then a wide spread will kill your profits.

But what if you've got a healthy margin and a healthy strike rate?

Let's have a look...

Here's the assumptions I've made about costs.

Costs	Spread	Commission	Other	Assumed level	Unit	Multiplier
Spread betting	1			1000	1	50
Futures	0.25	$5.32		1000	1	50
SPY	0.025	$5.00	0.30%	100	0.1	500
Fideltiy Funds Net	0.025	$5.00	0.50%	100	0.1	500
Fideltiy Funds Net (No fees)			0.50%	100	0.1	500

Same as the previous post before mostly. Market is S&P 500, emini s&P 500 or SPY or equivalent from Fidelity funds network.

Note with regard to the Fidelity funds network, this is a hypothetical comparison because the amount you can invest within the ISA wrapper is limited + you cannot go short + I have not investigated the tracking error of the S&P 500 equivalent funds. Fidelity funds network has no switching fees or commission on some funds. I've used this as the frictionless scenario.

There may be similar schemes available with a SIPP, but I haven't checked. 

Finally, as far as i know, Capital gains tax is due at 18% on realised gains over £10,100 in the UK. Some tax advisors say this should be taxed as income, depends who you speak to who the day of the week it seems.

CGT is liable on Shares & futures but not spreadbetting or fidelity funds network ISA wrapper.

The data does not include dividends.

Scenario 1:

Trades: 200
Winners: 124
Losers: 76
SR: 62%
Ave. Winner 2.83%
Ave. Loser -2.22%

NB these are the results I have for trading the AMI system on the SPY since 1997. Long >0.5 and short <0.5.

 

You can see that the wider spread on spread betting reduces returns, but you gain a lot by avoiding CGT. So if you have a reasonable margin on your trades then spread betting is worth it, but only because of avoiding CGT.

Naturally if you expect your annual realised gains to be closer to the CGT threshold, then you might want to consider the reduction in returns you'll feel from the wider spread. Many traders would be happy with £10,000 profits each year so it's something to consider. Naturally futures comes with a higher cost of entry with the emini S&P 500 have a $50 per point multiplier. 

Perhaps you could trade with CGT liable methods until you hit the annual threshold then switch to tax efficient vehicles?

NB I've ignore $/£ differences here. The example above is for comparison only.

Scenario 2:

Trades: 200
Winners: 150
Losers: 50
SR: 75%
Ave. Winner 1.00%
Ave. Loser -1.50%

Here I'm looking at the results for a system with a high strike rate, but with a the average winner being bigger than the average loser. It still makes a profit due to the healthy strike rate, but there's not much margin for error on each trade.

Here we can see returns are better with low bid/ ask spread vehicles even when taking into account CGT. I see many systems marketed in such a high strike rate/ low ave trade ratio and naturally none of them take into account the real cost of trading such a method.

More to come...

The real cost of trading

Sorry for the hiatus in posting, I've had a brief holiday and have been entertaining my visiting parents.

Looks like I've got some catching up to do, with DV punching out some fascinating on regime trading/ switching.

On another note, one thing that I've needed to complete my trading research is a true appreciation of trading costs.

I posted about this previous here in regard to investment costs, but have been doing some research on trading costs. 

It's relatively easy to factor in trading costs when you are testing a system, but I wanted to perform a broad sweep looking at the various options available in the UK.

• Would certain systems suit certain trading vehicles?
• Are you better designing systems with costs in mind?
• What about tax implications?

In the UK, there are a number of trading vehicles available.

• Spread betting - Basically futures trading with no commission but much wider spreads. Tax free.
• Buying shares - US or UK. Discount brokers such as Interactive Brokers. Stamp duty applies in the UK. Capital gains tax applies over £10,000 threshold each year. Tight bid ask spread on SPY.
• Futures - flat commission rate usually. Capital gains tax applies over £10,000 threshold each yea - Depending on which tax department you speak to! Very tight bid ask spread. Based on emini S&P 500 $50 per point.
• Funds network - Fidelity funds network allow free switching.

To compare the various options I've had to make some assumptions, but I think these are reasonable.

I've tested a hypothetical system (actually based on AMI historical returns)

54% Strike rate
Av winner: 1%
Av loser: -1%

200 round trip transactions in a year.
Av length of trade 10 days.
Market: S&P 500, SPY, Emini S&P 500. I assumed they were all the same level, but adjusted SPY to $100. No re-investment of profits.

For assumed costs, see the attached spreadsheet below. These include bid/ ask spread and commission where appropriate based on Interactive brokers pricing. Spread betting based on IG Index.

Assuming an average risk per trade of $1,000 (I've ignore any currency conversions for the moment).

Frictionless returns are $16,000. Av. gain $1000, Av. loss $1000

Here's how the other vehicles stack up:

Spread betting: +$2,000 total return. Av. gain $930, Av. loss $1070
Futures: +$10,040 total return. Av. gain $970, Av. loss $1029
Share purchases: $9970.00. Av gain $970, av loss $1029
Fidelity Funds network Switching fee of 0.5% round trip: $10,945, av. $975, av loss $1025
Fidelity Funds network no switching fee: $11,940, av. $980, av loss $1020

Interesting to see how poor the returns are for spread betting. This is mainly down to the large spread compared to other vehicles. There is no 'cost' in terms of commission, which may fool some people into believing they are dealing for free, when they are certainly not.

There appears to be little difference between futures and share purchases, though I haven't really accounted for leverage.

The Fidelity funds network has potential, but the choice of funds with low fees and low switching fees is small + I'd need to do further research on tracking errors within those choice of funds + you can't go short.

Tax

Ah tax - I haven't accounted for tax in any of this, but its worth noting that with the UK capital gains tax threshold at £10,000, the returns mentioned would be reduced very little if at all.

Considering how poor returns are from spread betting, it could pay to ensure you don't put the tax horse before the trading cart.

More to come soon. This is just one hypothetical system. I'm going to be playing around with various inputs such as account size, turnover, av. win/ loss etc.

Download Trading cost comparison

Costs

I've been researching trading and investing costs from a UK perspective and was struck by this tool available at Vanguard.

This tool allows you to compare your returns on the same investment adjusting the expense ratio. I was aware of the logic and research into the impact of costs in eroding long term returns, but I'd never seen it so graphically illustrated. 0.3% vs 1% annual costs may not sound like much of a difference, but it does!

1% annual management fees:

0.28% annual management fees:

Managed funds vs cheap index trackers becomes a heated debate and there's evidence for both sides of the argument. For me, the cheap index tracker argument wins it and I made this choice when I set up my pension not so long ago.

Trading costs

So what does this mean for trading?

Well it once again stressed the importance of keeping costs low. If you are using an ETF to invest with, that's great, but trading costs can mount up in the form of switching fees and taxes.

The US seems to well set up for this with Rydex funds allowing you to switch (say between S&P 500 long and S&P500 short) for free within their fund network. We just don't have this in the UK. To trade UK ETFs in the UK in a tax efficient manner, you need to use a self select share ISA which has annual fees and per trade fixed commission. I need to do the maths on the threshold beyond which this becomes reasonable.

The best option I can find for tax efficient investing is the Fidelity Funds network. This allows you to invest in funds within an ISA wrapper with switching fees of 0 - 0.25%. They have low cost tracker (ish) funds which might serve the purpose of tracking the FTSE.

A self select ISA might work ok, but again, I need to do the maths. Annual fees can be up to £60 with dealing costs of at least £8 to £10 per trade. On a small account, that will wipe out any tax advantages if you trade too much.

Coming up with a costs table that that compares costs for long term/ med term/ short term trades in a matrix against high turnover/ med turnover/ low turnover will be no mean feat, but could be as important if not more important than the system itself.

I hope to compare:

Spread betting
CFDs
Futures
ETFs/ Index trackers
ETFs within an ISA wrapper
Funds within an ISA wrapper