mindmoneymarkets

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.

Extended volcanic weekend reading

I've had a lot of time to kill over the last few days thanks to busy travel schedule made even busier by the volcano. We were due to fly from Vancouver at 4 on Thursday via the cheapo Canadian Affair (Thomas Cook airlines). The website kept saying the flight was due to leave for Gatwick at 7.15 PM, just 3 hours delayed. Several phone calls to their customer service claimed the same. This was despite everyone else in the entire world knowing that Gatwick was closed unlikely to open in time for us to land. 

Shoddy customer service is par for the course in my experience with Canadian affair. With low expectations we arrived at the airport, walking past the closed BA desks to a small but confused mob of people at the Canadian affair desks.

One hapless chap was trying to tell us what was going on, not helped by the fact that not a single Canadian affair central office bod had deemed it useful to stay up late, so no-one at their end could be contacted.

The plan was to fly via Glasgow then a 12 hour coach ride down to London. People we confused as to why crappy little Thomas cook was flying and not BA etc. The captain was brought out to explain that Glasgow was open and the cloud had lifted over that airspace. We had been given one of the slots in the lottery.

Eventually we took off for Glasgow, but landed in Manchester with a mercifully shorter coach ride to London. We didn't realise just how lucky we were to make the wedding on Saturday until we saw the news in the UK and saw the full extent of the flight ban.

Anyhoo, on to the book review....

The delays over the weekend weren't too bad and with all the travel we've been doing, I've been able to finish off too very good books. 

Reckless

The first is Reckless: The Rise and Fall of the city by Phillip Augar. I was a big fan of his previous book - Merchants of Greed, written about the dangers of investment banking from a first hand perspective. It was very well researched and prescient given what was to come with the Credit Crunch.

Reckless (also released as Chasing Alpha), takes a wider look at the City of London and how it rose to prominence in the last couple of decades and the implications this had during the credit crunch. Augar takes a look at the political, regulatory and geographic factors that all contributed to the city's success. The FSA's light touch regulatory environment played a crucial role in ensuring business took place through London.

With the election debate raging in the UK, the political implications are fascinating. The book is apolitical, explaining how previous governments all played their part. The biggest blame has to go to the most recent labour govt though as the city boomed to dangerous levels under their watch. It seems the govt was too entranced by the money pouring into public coffers to dare question the risks that over reliance on this sector posed. Rather like the banks and hedgefunds themselves who were quite happy to dance until the music stopped.

I enjoyed the book and thought that the sections on regulation and the history of the city were particularly strong. Some sections were disappointing though with the section on Northern Rock revealing nothing more than has already been reported elsewhere.

I'd recommend it though particularly with the UK general election round the corner. This and the next book I'll be mentioning both give lie to Gordon Brown's claim that Britain has been an innocent victim of a US led global credit crunch.

Far from being an innocent victim, consider the following:

• 50% of the dangerous OTC derivative trades went through London thanks to the light touch regulation. The recent Goldman's headlines involve a trading working from a desk in London.
• The same regulation played a role in the collapse of Lehman brothers thanks to the use of their repo 105 accounting sleight of hand, made possible by lighter UK accounting rules. 
• Many British traders were involved in the creation of the Credit Default Swap market as Gilliant Tett outlines in her book I review below.
• AIG Financial Products was the division of AIG responsible for the Lion's share of the firm's losses due to taking on CDS liabilities. This division based mainly in London. 

Fool's Gold

With irony, I finished Gillian Tett's Fool's Gold, just as the news was breaking on the Goldman Sach's charges. The story chronicles the creation of Credit Default Swaps and other OTC derivatives by focusing on the small JP Morgan team responsible for their creation.

I was absolutely gripped by the narrative. Not only is the book well researched, it is a heck of a good read. We start with the tales of the close knit group excited by the financial game changer their created and move forward through the years as other banks latch on to the idea without fully understanding its implications.

The JPM team originally applied CDS to commercial loans but couldn't figure out a way to apply to mortgage securities due to lack of past data and concerns over correlation. Other banks quickly out paced JPM with their derivatives trades as they applied CDS to the one area JPM couldn't get to work - mortgages. Three times they tried to figure out what they were missing, what other banks had spotted that they couldn't and each time stepped back from the deals.

The truth was quite simple as the Goldman's case implies. Other (investment) banks either did know about the risks and pushed through deals anyway, or just didn't understand what they were buying and selling. 

The are some incredible lessons to be learned for ones personal trading such as not trading markets,  ideas or strategies you don't understand.

I found Fool's Gold to be absolutely fascinating and highly recommend it.

Leverage & prop trading

It's interesting to read the various reactions to the Volcker plan. Some are calling Obama a communist while others are backing it.

Unfortunately there seems to be little by the way of solid detail on the plans, but I agree in principle that something major had to be done. Separating retail and more speculative banking was one way of doing hits. The devil is of course in the detail. One of the best posts I've read on it is here from someone who used to be in the thick of prop trading activity.

Interesting thought:

"Never mind the issue of if my friend trading merger arb with my deposits is any more or less risky than his bank instead taking the money and lending it out to small businesses and homebuyers (cause that's what they do!) - I think the past few years have cemented the fact that mortgage lending is not necessarily less risky, but it certainly looks better on paper, in terms of subjective categories like benefit to society."

This leads nicely to an interview with Richard Thaler, one of the leading lights in behavioural economics.

Again, another choice quote:

"What was the ultimate cause of the financial crisis? Poor regulation? Greed? Bad market signals? Human frailty?

Leverage caused the crisis—and I would say that is a pretty uncontroversial statement. Human frailty comes into play at two levels. One, the people who were taking out the subprime mortgage loans—many of them didn’t understand what they were doing. Two, the C.E.O.s clearly didn’t understand what their traders were doing. I call that the “dumb principal” problem. Go down the list—A.I.G., Citigroup, Bear Stearns, Lehman Brothers. These companies were destroyed or devastated by a small part of the firm that was hurtling forward and was risking the entire firm. The people in charge were either greedy or stupid, or possibly both"

Going back to Kid Dynamite:

"In addition to trying to separate commercial banking and prop trading, wouldn't a good first step to be to actually separate the commercial banks from the non commercial banks?   People aren't mad because GS is making money trading - they're mad because GS is making money trading with what they (the people) think is taxpayer money or taxpayer backstops.

The decision to allow non-banks access to  (near zero cost) Fed funds resulted in these non-banks making extreme amounts of money which angered the populace.

As I said, I fully understand the desire to implement a situation where commercial banks do not engage in proprietary trading.  However, the real problem isn't proprietary trading - it's leverage - it's actual risk.  Even if/after we successfully separate proprietary trading from commercial banking, what are we doing to prevent the next  Long Term Capital Management blowup?"

Putting these two together, I personally gain a sense of clarity on the crux of the problem. I hope it helps you.

As the quotes above have inferred, it's not prop trading, it's not bad loans, its any risk that is over leveraged. If Northern Wreck wasn't so dependent (leveraged) on short term funding it may not have have starred in act 1 of the crisis. 

Aleph blog has further thoughts on the role of leverage in the crisis

PS an update to my little conspiracy theory. Goldmans could (surprise surprise) be the bank with the most to lose with a ban on prop trading. By extension, you could argue they are one of the biggest market makers out there. By further conspiratorial extension, you could argue that as Goldman's are one of the most active program traders on the NYSE, they have the ability to nudge the market a little here and there.