passive fund managers, index tracking, investments, active fund managers, Kingston, surrey, London uk

The Hidden Cost of your Investments

On the Financial Services Authority (FSA) website there is an article titled ‘The Price of Retail Investing’. This article looks at the effect charges have on retail investments.

One of the many statistics quoted was that between 1987 and 1998 the average market rate of return for Life insurance funds was 8.45%. However, the average return to the investor was just 4.44%

Source: The Price of Retail Investing in the UK FSA Occasional Paper Series 6 by Kevin R James, Feb 2000

How could that possibly be?

Most of us have stockmarket investments - usually wrapped up in pensions, ISAs, unit trusts, insurance bonds and endowments.

We invest in these products with the hope of a ‘decent rate’ of return and because most of us lack the expertise to manage our own investments.

Let’s go back to absolute basics for a moment. The amount returned on any investment can be expressed by a simple formula: ((Initial investment plus growth) minus charges). For the purposes of this article I am going to ignore growth and concentrate purely on charges.

There are three types of charges that you may pay. Two are visible and you should already know about the. The third may come as a surprise!

Many products have initial charges which are usually expressed as a percentage of your investment and are commonly between 3-7%.

They can either be dressed up with fancy titles such as ‘bid to offer’ spread and ‘allocation to units’ up front, or levied as sliding exit penalties over 5 or more years.

Don’t be fooled by the titles - ultimately they are charges levied on your investments and paid for by you. They are often used to pay commission, more commission means more charges!

Okay so let’s assume that your money is now invested in a selection of actively ‘managed’ or ‘equity’ funds.

These funds usually have an annual management charge (AMC) of somewhere between 1% to 2.45% of the value of your investment,
each year.

You are paying these managers to use their expertise and, without taking inordinate risks, to give you a better rate of return than….. ‘not managing it’!

In other words you entrust them to buy and sell assets on your behalf, with the hope of a ‘decent return’.

3. Iceberg Charges

Having established that you’ve paid initial and annual charges, you might think that would be it. Surely no additional costs?

Well you’d be wrong! The ‘visible charges’ we have mentioned do not cover the cost of trade (ie the cost of your fund manager buying and selling shares on your behalf trying to ‘beat the market’).

The cost of trade is a so called ‘iceberg’ charge, incurred every time shares are bought and sold. These include stockbroker fees, tax, ‘market impact’ etc.

The effect of these iceberg charges are overlooked by most investors. In the article The Price of Retail Investing contained on the Financial Services Authority (FSA) website the, author, Kevin R James estimated that if an equity fund traded all its shares each year (ie 100% turnover), this would add a further 1.8% per annum ON TOP of all other ‘visible’ charges.

In 2006, the average turnover of equity funds was 79.6%. In other words you could typically add 1.43% in addition to AMC of 1 to 2.45% every year. One fund manager had a 280% turnover resulting in an additional 5%*

This may partially explain why your investments never seem to do as well as you expected.