View from the glass house
Are fund charges too high? Your answer to that question probably depends in large measure on whether you are part of the fund management industry or a customer of it. But, whatever your opinion, we can all agree that transparency in charging is essential. If charges for a service are clear, then everybody has a straightforward choice: am I prepared to buy that service at that price; is it value for my money?
The service offered by a fund manager has several facets. It provides access to the stock market at a much lower cost than a retail investor would pay if investing direct. It gives automatic diversification. It gives safe custody of assets overseen by a trustee or depositary. And, if you go for an actively managed fund, there is the possibility at least of doing better than the market return.
That is the service. The cost is given by the total expense ratio which tells the investor the charges associated with managing and operating a fund. This includes not only the charge paid to the manager, but also other fees paid by the fund, for example, audit, trustee and registration fees. This is information that has to be disclosed to consumers under EU rules.
But a debate is currently raging around the TER on the grounds that it does not include other costs that may be incurred by the investor. A number of people are advocating a new and different measure which brings together in one simple figure all costs – including entry, exit and performance fees, and the costs of trading the underlying portfolio – to allow investors to compare different funds and make an informed decision.
Setting aside for a moment the fact that the industry is completely constrained by the EU rules, let us examine these a bit more closely.
Exit charges are very rare indeed in the funds industry and anyway do not lend themselves to a simple upfront formula – where they exist they are often tapered so they vary depending on when the investor decides to leave the fund. Similarly performance fees are pretty infrequent, and tend to be concentrated in offshore funds. Again, how can you specify them in advance? You cannot do it on the basis of recent performance, since we all know it is not a guide to the future.
What about initial charges? The annualised effect of initial charges depends entirely of course on holding period. But the RDR is anyway likely to make them much less of an issue. Nowadays, the initial charge is generally rebated to the investor or to the IFA as commission. Very little is retained by the fund manager. The RDR will prohibit the payments to advisers, and is likely also to prohibit customer rebates. Initial charges may soon become an endangered species.
Which brings us to trading costs. The accusation has been made recently that the TER understates the true cost of investing because it does not include these costs. I think this accusation is completely wrong-headed.
It is wrong-headed first because the impact of trading costs cannot be sensibly separated from the impact of the associated investment decisions. Is anybody seriously saying that a manager should forgo a profitable investment opportunity because the trade would incur costs to the fund? Of course not, and this points to a clear difference between fund charges and trading cost. If fund charges are reduced, all else being equal, the investor’s return improves. But lower trading costs do not necessarily translate into better performance – it could be the reverse. Adding the two together is therefore like adding apples to pears.