Golden rule number three - control costs

In the third of our series of golden investment rules, we look at one of the few things you are able to control when making investments - costs.

Charges over the long term can have a significant adverse impact on investment returns; by way of illustration, an extra 1% charge on a £100,000 investment achieving average returns over 25 years will reduce your own return by over £100,000, i.e. more than your original capital investment. You might expect that funds with increased charges are able to justify these by offering better investment returns to compensate. However, numerous studies have found that, on average, funds with higher charges perform worse than those with lower charges.

Indeed, lower charges are quite a reliable indicator for long term out-performance; as a Director of leading fund researcher Morningstar put it:

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. . . . Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” (Kinnel 2010)

As a regulatory requirement, all UK registered funds must state an ongoing charges figure (OCF) as part of their literature. This includes the annual management charge (AMC) levied by the fund manager, as well as some other charges involved in running the fund. However, what investors should be aware of - and what is seldom reported or acknowledged by the investment industry - is that there is a significant number of costs that are not included in the OCF. For example, all costs and taxes associated with buying and selling stocks within the funds are completely ignored and not reported. The best proxy for these costs is the portfolio turnover rate (PTR). PTR is expressed as a percentage and is the number of individual holdings that are bought and sold within the fund (a PTR of 100% means that all of the stocks have changed in the year). In July 2012, following heavy lobbying from the industry, the investment management association (IMA) made the retrograde step of removing the requirement on regulated funds to publish the PTR. More worryingly, research conducted for the True & Fair Campaign showed that, at the start of 2014, only 6% by number, and 14% by aggregate fund size, of UK registered funds were still reporting a PTR figure.

You may feel that these costs are a small percentage of the total charges, however, research conducted in the US1 found that the hidden extra costs incurred by actively-managed funds was conservatively placed at 1.15% p.a.. To make matters worse, UK retail investors are currently paying 58% more on average in costs than US retail investors!

What investors should take from this is that you need to be aware of what your investments are costing. You also need to dig deeper than just the AMC or OCF provided in fund literature when selecting funds.

You may be reassured to note that the average PTR of investment portfolios on which Moore Stephens advises comes out at under 10%, and has an OCF of less than 0.30% p.a..

1 The Arithmetic of “All-In” Investment Expenses. John C. Bogle (2014)