Investors should be wary of fund managers who turn over their portfolios too much, advisers warn – as they can incur large additional costs that are not stated in their annual management charges.

With performance fees on funds set to rise, advisers say it is becoming even more important for investors to look into the hidden costs of their investments, which can act as a drag on performance over time.

Fund managers who buy and sell shares too often can rack up extra costs for investors in the shape of stamp duty, commission to stockbrokers and the difference between the buying and selling price for shares – the “bid/offer” spread. Some funds have an annual turnover rate of more than 500 per cent.

“When someone turns over a portfolio more than 100 per cent in a year, you could legitimately ask: what are you doing?” says Robert Reid, an adviser at Syndaxi. “I think the method of getting information to the average individual is so poor that they’re making their decisions on advertisements as opposed to reality.”

Alan Miller, founder of SCM Private, points out that the average UK All Companies fund has an annual turnover rate of 89 per cent. Each trade, he calculates, costs 1.04 per cent – comprising 0.5 per cent stamp duty, 0.3 per cent commission paid to stockbrokers (0.15 per cent on both purchase and sale) and 0.24 per cent (0.12 per cent each year) on the bid-offer spread. This adds 0.9 per cent to the stated average total expense ratio (TER) of about 1.6 per cent.

However, none of these costs appears in a fund’s TER. Investors can check a fund’s annual statement for details of extra costs incurred in dealing, such as 0.5 per cent stamp duty and commission to stockbrokers – but bid/offer spread costs are not included at all.

“If the end investor knew how much his turnover was costing him, he’d have a fair picture of how much his fund cost and he’d probably make a different decision,” says Miller.

Finding this out will be even harder from July, when new rules known as Ucits IV will waive the requirement for an annual statement to include portfolio turnover figures.

Mark Sherwin at the Investment Management Association argues that existing portfolio turnover figures are open to misinterpretation, as they include times when the fund manager is forced to buy or sell shares because of inflows and outflows of money into an open-ended fund.

He adds that if fund managers had to worry about keeping transaction costs down, they might not be able to take full advantage of investment opportunities when they arose.

Even so, Dan Norman at TCF Investment says: “It’s a shame that the new key investor information document won’t have that information in it, as it’s a key part of the decision that you want to make – what is the true running cost of my fund?

“If we do get lower fund fees, then trading costs will be even more important as that will be a bigger slice of what the investor pays.”

Miller argues that funds with lower turnover actually perform better. The 20 funds with the highest turnover last year in the IMA’s All Companies sector returned just 4.7 per cent to investors in the three years to the end of February. The 20 funds with the lowest turnover had an average performance of 16.8 per cent over the same period.

But how often fund managers buy and sell shares in a mutual fund is only part of the problem. Investors can also incur dealing costs in their own portfolios by ditching poor performers too readily.

Nick Blake, head of sales at Vanguard, the low-cost fund manager, says that part of the blame for this falls on financial advisers, who prefer to be seen taking action rather than doing nothing.

Stuart Fowler, founder of No Monkey Business, says that private investors must share some of the blame, too. “Customers have expectations about what advisers will do,” he says. “First, they have expectations that they will buy funds that have good past performance; second, they will tend to put the adviser under pressure to get rid of things that aren’t performing well.”

However, there are times where buying or selling a fund is the right thing to do. Blake says that investors are often too risk-averse when a stock rises and want to lock in the gain, so they sell early. In contrast, they are more risk tolerant when their fund has fallen in value and do not want to lock in a loss, when it might be better to sell.

Equally, fund managers who make good decisions on portfolio turnover can deliver good returns. “If each time you make a decision it’s a brilliant decision, it doesn’t matter – what you don’t want to have is lots of decisions that lose money,” says Miller.

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