Hidden fees ‘like Loch Ness Monster’

Similarly, accusations that funds contain hidden fees are simply heresy, the Investment Association suggests in its latest report, in partnership with fund research firm Fitz Partners.

Or in the words of the trade body, which is bankrolled by fund managers: “The report finds zero evidence that funds’ returns are affected by hidden fees lurking within.” It suggests that “hidden fund fees” may in reality be the “Loch Ness Monster of investments”.

The IA validates its assertions with the headline findings of the study, which analysed the performance of 1,350 active and passive funds between July 2012 and May 2015.

The body opted to focus solely on bundled share classes for, it said, consistency given the timing of the introduction of the Retail Distribution Review and the subsequent unbundling of platform and adviser charges.

Entry and exit charges were omitted from the study because their effect on the overall outcome is minimal and they do not reflect what is happening on an ongoing basis, according to the IA.

So too were performance fees, which can be recurring, but were out of scope because they incur only when the fund outperforms a specified benchmark, it added.

The IA found on an asset-weighted basis, transaction costs across the IA equity sectors in the 34-month period were 0.17 per cent – the result of the average portfolio turnover rate of about 40 per cent.

Its research also shows that it was more expensive to trade in some sectors, such as China, than in very liquid markets such as North America. What is more, active UK All Companies funds had an average transaction costs of 0.19 per cent compared to 0.05 per cent for tracker funds.

“This clearly contradicts claims often made that trading costs amount to several multiples of fund fees, as can also be seen from the comparison with average ongoing charges (OCF) which across all equity sectors are on average 142 bps and for UK All Companies specifically slightly lower at 122 bps,” the report stated.

The IA hypothesised that if there were ‘hidden costs’ it would expect the average fund return to fall short of the benchmark return – which averaged to 12.50 per cent – by much more than 1.59 per cent – the sum of the transaction costs and the OCF.

However, contrary to this expectation, funds covered both ongoing and explicit transaction costs and delivered returns averaging to 0.71 per cent higher than that of the benchmark, the research found.

It should be noted that between 2014 and 2015 funds underperformed the benchmark, but only by 0.37 per cent – far less than the expected shortfall of 1.56 per cent.

The report said: “Post-RDR it should be possible to measure much more clearly fund manager delivery which will help to inform the value for money debate and the results would be even better using the new unbundled pricing of the ‘new’ primary share classes.”

By its own admission, the IA notes that the lack of empirical data on implicit costs – relating to the costs inherent in accessing capital markets – meant it could not definitively isolate manager skills from transaction costs.

“For example, a low net return and realised outcome may indicate poor stock and securities selection and significant implicit transaction costs, or a combination of both these factors,” according to the body.

It added that one indicator of high transaction costs would be very high portfolio turnover rates.

However, the study found the average portfolio turnover rate was 40 per cent, which also “brings the hidden-fees hysteria, and claims of fund manager overtrading, into doubt.”

The IA reaffirmed plans to publish a ‘Disclosure Code’, which will standardise fee disclosure including implicit cost estimates across all investment products.

The topic of fee transparency is one that touches a nerve with many industry commentators. A 2014 White Paper by Professor David Blake, director of the Pension Institute at Cass Business School, suggested that concealed costs – such as bid-ask spreads and transaction costs in underlying funds – can make up to 85 per cent of a fund’s total transaction costs.

Andy Agathangelou chairman of the Transparency Task Force, labelled the report as “confused”, adding: “The topic of hidden fees plays an important part of the FCA’s study into the asset management market.

“The Department for Work and Pensions is working with the FCA to improve the disclosure of transaction costs in workplace pension schemes. Why would these regulatory initiatives be taking place if there is no issue with hidden fees? It is like the IA is trying to wish away the problem by saying it does not exist.

“I feel sorry for financial advisers because they have a duty to ensure that their clients are well informed about every facet of their investments. They might find themselves being criticised or litigated in the future if they do not make their clients aware of all charges or to the fact that they are hidden costs.”

Gina Miller, a longstanding campaigner on fund managers’ fees and a founding partner of wealth boutique SCM Private, is somewhat more forceful in her criticism of the 22-page report, claiming it was not worth the paper it was printed on.

Ms Miller said: “Of course over the long-term the returns from investment after costs must equal the market returns less all the costs (including transaction costs). Selecting arbitrary time periods or funds does not change this basic fact.

“Instead, the IA has taken a short time period, of just three years, and a convenient time for analysis in which many active funds fared well due to their inherent small/mid-cap size bias. They have also ignored completely the spread element of transaction costs and survivorship bias.”

Transactional charges, relating to buying and selling of a fund’s investment is seldom included in a fund’s ongoing charges because they are variable, according Andy Brooks, chartered financial planner at Peterborough-based Brooks Wealth Management.

For fund houses, these fees are almost impossible to present to the consumer, and any attempt to estimate the likely yearly cost could mislead investors, Mr Brooks said.

Mr Brooks added: “We look at how much a fund returns given its unit of risk. The quality of the investment team behind the proposition, the size of the fund, and whether it has been around in the market for a while are also important considerations. The focus on charges is overrated. Realistically, you should look at what the client wants. They want to know is whether or not their investment has grown.”

Myron Jobson is a features writer of Financial Adviser

Performance of equity funds across IA sectors from July 2012 - May 2015