If you want a sure fire way to pick a good investment fund what is the best method?
Past performance? League tables? Manager skill? Star ratings? A dart board? The bottom of your tea cup? Actually the answer is very simple:
Low cost funds beat high costs funds!
TCF Investment looked at the returns of the three IMA Managed sectors. It ranked all the funds in the sector by current Total Expense Ratio (TER). It then looked at the performance of the low cost quartile (cheapest 25%) and the highest cost quartile (most expensive 25%) relative to the average performance of all funds over 3 and 5 years:
|3 years %pa||5 years %pa|
|Dearest less cheapest||1.15||1.08|
|Dearest less cheapest||1.10||0.90|
|Dearest less cheapest||0||0.59|
|source : Morningstar 2011|
The analysis shows that the lower costs are a very strong predictor of future returns – beating or meeting the returns from their higher cost peers in every case.
Yet despite the clear evidence of the pivotal significance of cost when choosing a fund, there is effectively no price competition across the UK fund management industry. Investors and their advisers need to take a proper, careful look at Total Expense Ratios (TERs) and Portfolio Turnover Rates (PTRs) of funds when choosing one fund over another.
“Investors and advisers need to remember that every pound of investment cost is a pound lost – forever. In the current low return environment high costs means investors are effectively trying to walk up the down escalator – a sure fire way to get nowhere fast.
Have you ever wondered why your funds don’t seem to do as well as the performance tables suggest? Well there is a there a feature of league tables that might help explain why this is. Data from the Investment Managers trade body, the Investment Management Association (IMA), survey July 2011 shows that they collected data on 153 new funds launched in the last 12 to December 2010 and there were 2574 authorised funds in total (at the end of December 2010).
When you add these numbers to the previous 11 years data you find that:
- The total number of funds launched in the last twelve years was 2660
- Total number of funds in existence at the end of 1999 was 2,437 and at the end of 2010 there was 2,574
- Therefore the number of fund closures (including mergers) was 2486 over the same period
This means the industry has effectively had more than 100% turnover of funds over the twelve year period. Or about half of the funds in any 5 year period are merged or closed – and that means their track records have been lost (as they are no longer in the performance league tables).
It seems a reasonable assumption that the funds being closed or merged are the poor performers (Data from Vanguard confirms this). So if you look at the 5 year sector average performance you are really only looking at half the story – the good half. (Note there are rules about mergers but the fund manager will naturally always try to ensure their funds are shown in the best light).
So if for example a manager has two UK Equity funds, and one does badly, it is possible to merge the poor performer into the good performer. This will see the poor performance disappear from the league table, the investors in the poor performer suddenly appear to have a better performance in the league table (even though nothing has changed), the average performance of the manger goes up, and the performance of the sector also improves slightly. This factor is known as survivorship bias – the performance record is biased in favour or the survivors.
This means that even past performance tables may not be an accurate guide to past performance!
If possible make sure you compare your funds with an index to see what is really going on. Check to see if any league tables are adjusted for survivorship bias (i.e. have the track records of merged or closed funds added back in). And beware that you don’t buy a manager that has “upped” their performance via merging away the poor funds.
Big funds are more likely to be making their managers rather their investors rich. Fact.
Data from the Investment Management Association (in their latest Annual Survey) shows that the average fund size (mean) in 2001 was £126.5m whereas by 2010 it had grown to £278.8m. Data from Lipper shows that the average Total Expense Ratio (TER) has risen over the same period from 1.5% to 1.7%.
This means the average fee charged to manage the average fund has grown in ten years from £1.89m to £4.74m in ten years.
|Mean size £m||126.5||278.8|
|Mean fee %||1.5||1.7|
|Source: TCF Investment|
This 250% fee rise is equivalent to 9.5% pa. Inflation over the period has been about 30% or 2.65%pa.
Investors will find it hard to understand why the fees don’t go down as fund gets bigger. The costs of running a £300m fund are not three times those of running a £100m fund, assuming the fund manager’s salary hasn’t tripled.
The IMA survey also shows that since 1993 the main driver of fund growth has been net inflows (i.e. investors saving more) rather than asset performance. This means that investors are putting new money into funds faster than their managers are creating value and they are being charged an ever increasing fee for the privilege. This would not be allowed to happen in other industries. Consumers and advisers need to put much more pressure on expensive funds – by moving their money to cheaper ones.
If the average fee of the average fund goes down then the average investor will be better off. Fact!
There are about 17 million people in the UK who have collectively saved £158 billion into Cash ISAs many currently earning very low levels of interest. If they are saving for the long term many of these investors will be trying to protect against inflation with an inappropriate asset class – their spending power is likely be eroded by inflation over the long run.
It is the same with Child Trust Funds. Too many investors have taken the supposed “safe” option of cash savings for children despite the 14year or longer investment horizon - regular saving into low cost equity backed investment is likely to prove a much smarter option. Long run returns from Equity have averaged 4% more than cash.
A good financial plan will match the investor’s mix of investments to their risk profile and future income needs - getting a good plan is half way to the solution.
But advice can be priceless…
For example, if someone without advice on National Average Earnings of £25,500 saved 3% of their salary a year for 40 years in a tax inefficient way with low returning assets (2%pa net, with salary inflation at 2.5%pa) the final value might be £74,444 – and provide an income in retirement of £4,615 a year.
If, after good advice, they saved the same amount but with 20% tax efficiency on their savings and into an asset mix that delivered real returns of 3.5%pa year the final value would be £220,120 – which (with an improved annuity rate) could provide an income in retirement of £18,050 a year. That is nearly four times as much per year!
The value of advice could be a whopping £268,686(assuming this improved income over 20 years).
And of course this is just the savings side – debt/mortgage advice may add even more value.
The FSAs Consultation Paper on Platforms (CP10/29) contains a couple of areas that may be more significant than at first sight.
The cost of administration?
FSA expects platforms to charge a reasonable price for the administration that it provides. Let’s assume that fund managers used to pay 0.1% pa for transfer agency, 0.1% pa for fund accounting and 0.05% pa for custody via their outsourced admin provider. A total cost of 0.25%pa.
When using the nominee services provided by the platform the manager may now pay 0.05%pa for transfer agency, 0.1% pa for fund accounting and 0.02% pa for custody. 0.17% pa in total.
Does that mean the total cost for the transfer agency and custody that the platform can now charge for is a maximum of 0.08% pa (plus some small amount for the wrapper) to keep the total cost the same?
Is the FSA cunningly introducing a price cap for platforms? That would be very customer friendly!
Who needs a platform anyway?
FSA have said that they will require prompt re-registration of funds between platforms to be compulsory by 2012. About time – what is the point of a technology platform if it takes longer to move your fund than it used to take without technology?
Re-registration will likely drive adoption of ISO20022 message standards between platforms and managers. That means that anyone with the software to be able to read/send the message can play.
Customers will benefit from the adoption of message standards to drive speedy re-registration but it also means that IFA software providers can also use the same message standards to provide consolidated valuations. And share dealing platforms can integrate mutual fund trading simply and cost effectively alongside their Equity trading .....hey presto who needs an expensive platform any more??
Perhaps this time with a little sponsorship from the regulator will we really get low cost ownership of mutual funds adopted by millions more investors?
23 November 2010
My friends, family and colleagues will tell you that I am not backward in coming forward when it comes to some of the issues in financial services - so for the very first time I have decided to write a blog.
One thing that has really gotten under my skin is the fact that almost every person in the UK is being over charged by fund managers. I know it is a bit of a grand statement but it is true, there probably isn’t one adult in the UK that doesn’t have some sort of investment.
The fund management industry has simply forgotten whose money it is looking after. Charges have risen relentlessly over the decades when they should have been falling. As overall funds have grown in size it must be getting cheaper to manage them….so why are we not benefiting, it is our money not theirs!?
If Robin Hood had been a fund manager he would have ‘taken from the rich managers and given to the poor investor’ – reducing fees and passing on the savings to the investors.
I reckon that investors are paying at least £3bn a year more in annual fees than they should be - that’s £12m every working day and it shows no sign of slowing. And these are just the fund managers fees, then you have to add the costs of trading the stocks and shares within the funds (which is paid to the stockbrokers and investment bankers), that can make a huge difference to the funds performance.
It is time for a revolution that tips the balance back in favour of investors and away from greedy fund managers. Time to demand lower fees as funds grow.