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May 6, 2012 7:31 am
What is the real cost of investing? More than a decade into the great turn-of-the-century bear market, this question is becoming ever more acute. Returns have suffered, and the prospect of them being further eroded by charges and other costs can only be a massive turn-off for investors.
The question of costs is also coming up regularly in debates about pensions as defined contribution arrangements become more prevalent and auto-enrolment is set to take off in the UK. Expect European legislators and regulators to get interested soon.
It is a question of critical importance to the fund management industry. Fund management has to be a transparent business. If it is not, investors will lose confidence and nobody wins.
The trouble is that the question is difficult to answer to everyone’s satisfaction. We have a good measure of the costs of running a fund – the total expense ratio (TER). But the TER does not include the costs incurred when the manager trades the underlying portfolio. Some say this is surely a cost of investing too.
It does not stop there. As well as the explicit brokerage and stamp duty costs that make up trading costs, there are bid-offer spreads in underlying stocks. Then how do we take account of stock lending? How do we measure the cost of derivatives? What about market impact? And to cap it all, managers operate pricing policies designed to protect continuing investors from trading costs caused by significant inflows or outflows – so those costs do not fall on all investors equally.
It is easy to get lost in these complexities. But fortunately there is a reality check available. As the chief executive of one of IMA’s member firms once said to me, investment management is subject to more measurement than any other business.
And what better measurement than net performance – the actual return experienced by investors – which is measured with great precision. So is the performance of the benchmark index. And we know the direct charge paid by the investor – the TER. So if you subtract the TER and the net performance from the benchmark, what you are left with is the impact of the manager’s investment decisions, along with trading costs and all these other factors.
Some have chosen to call these the “hidden costs”. It is the sort of charge that easily gets political traction, and we have seen the battle cry go up in both the UK and the European parliaments. It is damaging because it sends the message to investors that they should not save for fear of being ripped off by the industry.
However, nobody has bothered to look at the magnitude of those “hidden costs”. So in a paper published on Monday, the IMA has done just that.
We found that, for UK index tracking funds, the net return over time was effectively the same as the relevant index, less the TER. There was nothing to suggest that “hidden costs” were dragging down performance.
Doing the same exercise for actively managed funds gives a slightly different measure, since the divergence from the index is the combination of manager alpha, or outperformance, and costs. But when this is measured across all funds, a lot of the alpha will cancel out.
We found that the average active fund underperformed the index by about 1 percentage point a year less than the TER. In other words, active management was on average adding about 1 percentage point a year to performance after everything was taken into account. No sign of any hidden costs here either.
When the IMA statistics team first showed me these numbers, I was surprised at how categorical they were. They held true over multiple time periods. They took account of survivorship bias. And it was the same for non-UK equity sectors as well.
The accusation of “hidden costs” is well and truly refuted by these figures. But that alone will not counter the suspicion that the industry could be more transparent still. And there is some merit in this argument. For example, although trading costs are disclosed in a fund’s report and accounts, this is not a document many investors see.
We are looking at how that could be improved. I encourage IMA members to implement what we recommend. After all, this is an industry that has never suffered detriment by being more transparent.
Richard Saunders is chief executive of the Investment Management Association
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