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Topics: Richard Saunders| blog| IMA
Here's a New Year puzzle for you. Fund A has annual charges of 1.5%, and in addition incurs annual trading costs in its portfolio of 0.2%. Fund B also has charges of 1.5% a year, but its trading costs are 0.4% a year. Which is better value for money?
There's a group of people out there who want you to believe the answer is Fund A - after all, the costs are lower, so you must get a better return.
Now here's another clue. Last year Fund A returned 1% less than the stock market index, while Fund B returned 1% more. In other words the extra 0.2% of trading costs resulted in a 2% extra return. In my book that would be pretty good value for money.
These are illustrative examples. It would be wrong to argue that funds with higher trading costs always perform better. But the point is that they might. And you do not know unless you look. The costs of trading the portfolio are inseparable from the impact on returns of the associated investment decisions.
The combined effect of trading decisions and their costs is reflected in a fund's net performance, which is measured after published charges, after trading costs, and after any other effects including the bid/offer spreads on underlying investments.
There is no hiding place for the fund manager from the cold facts of net performance: if he is not delivering for investors, the fund slips down the performance tables and, in the absence of improvement, is likely to lose custom to its competitors.
This year is seeing a renewal of the misguided campaign to include trading costs in fund charges. That campaign is misguided because it would mislead investors into thinking that trading costs matter in isolation from their impact on investment returns. It also ignores the iron discipline that net performance exerts on managers.
But, I hear you say, that still doesn't tell us what all this is costing investors. All these extras - trading costs, bid/offer spreads, stamp duty and the rest - are surely leeching money out of investors' returns, are they not?
The answer is no, they are not. How do I know? It's the cold light of net performance again. When I blogged on this subject before Christmas, I pointed to research we did two years ago which showed clearly that the combined effect of investment decisions and trading costs was positive rather than negative for investors. We have now done some further analysis to take account of performance to the end of 2011.
And guess what? The result is the same. For both index trackers and active funds, the ten year performance showed no sign whatsoever of so-called "hidden costs" pulling down performance.
For the record, FTSE all-share trackers returned an average 3.9% a year, the difference of 0.8% a year from the return on the index being exactly in line with average charges. And the active funds returned on average just over 4% a year, or 0.6% below the market - in fact recouping a significant amount of their typical charges of 1.5% or so.
These are the facts. I'd like to think we will hear nothing more about "hidden costs" to investors, though I suspect I am going to be disappointed. But we at the IMA will aim at least to keep the debate informed with the true facts.
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An extra-ordinarily dishonest argument
The same argument put by Mr Saunders could be put for not revealing ANY costs and is a position he would no doubt support. What is clear is if "costs" are to be given then they should be include all costs and not be a dodgy figure that arbitrarily includes some costs but excludes others. The public aren’t quite as stupid as Mr Saunders thinks or perhaps wishes and his sort of selectivity is the cause of so much distrust.
Posted by: PeterD
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Investors get what they don’t pay for
I’m not sure that the example given clearly demonstrates anything, given that the correlation between higher cost and higher return is not shown to have any causal link. There is no evidence that the extra trading activity over that single year resulted in the higher return at all – it could have been purely down to luck (a year is surely a rather short period in which to draw any meaningful conclusions about any investment performance, whether good or bad) or it could have been despite the trading activity. Part of the challenge when carrying out research on investment returns is to ensure accurate benchmarking (so that beta is not portrayed as alpha) and the avoidance of survivor bias (poorly performing funds disappear from the record, making the survivors look better – the IMA’s own figures reveal that 42% of the funds launched since 1960 had disappeared by 2006). Such adjustments are invariably used in academia where research that does not meet a robust standard is rapidly dismissed but it is less widely used I industry, where data mining to reach the desired conclusion is more common as the degree of scrutiny is less. Lots of trading might increase returns if the decisions are good but then again, it always has a cost. Therefore anyone opting for a high activity approach faces the possibility of one (and the possibility that the decisions may be less good, leading to lower returns) but the certainty of another. Investors in aggregate get the market return less costs, as Bill Sharpe pointed out in his short paper “The arithmetic of active management”, so if an investor’s costs are higher, their returns, on average, will be lower. Some will do better (by skill or luck) and others worse but it is notoriously difficult to identify skill in advance and then to profit from it. It therefore makes sense for investors to focus on the variables that they can control (costs, asset allocation and discipline) and avoid those that they cannot (future performance, fund manager luck/skill etc.). It is perhaps unsurprising that the IMA holds a different view, as it is the trade body for the investment managers whose interests are in persuading investors to buy expensive funds rather than less expensive ones; its members’ interests are thus not wholly aligned with those of investors. This is not a criticism of the IMA or the managers, as they all have their own constituents to serve but it is perhaps as well for investors to appreciate that such a conflict of interest exists when making their own choices about how to invest.
Posted by: Robert Lockie