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.
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.
"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.
"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
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:
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
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.