Hidden fund costs are hurting investors

September 9, 2013 11:52 am

Hidden fund costs are hurting investors

By Pauline Skypala

The easiest way to make money is to take it from other people: that is what the financial services industry does, and for proof of its efficacy look no further than the results last week of UK fund platform provider Hargreaves Lansdown. It reported a 28 per cent rise in pre-tax profits over the year to the end of June, and an impressive profit margin of 65.8 per cent. The company’s two founders are now billionaires, and shareholders have done well too, with the shares up more than 400 per cent over five years. They have prospered by sharing in the growth of customers’ assets.HL looks after £36.4bn and makes its money primarily from the cut it takes of the annual management fees of the funds available via its website. That is 75 basis points for funds levying the average fee of 1.5 per cent a year, of which it gives back up to 25-30bp to customers as a “loyalty bonus”.

The company’s customers are largely self-directed investors; they are not getting advice. And although 50-75bps seems a lot to pay for administration, there are few complaints. That is partly because HL does not disclose its share of the loot (its website states there is no charge for its platform services, unless you are buying an index tracker or exchange traded fund), but also because it is cheaper than buying direct from a fund group.

This brilliant business model is on notice. From next April HL and other UK platform operators will no longer be allowed to receive ‘rebates’ from fund managers and will have to charge an explicit fee for their services. Some have already moved to that model. Peter Hargreaves, HL co-founder, is worried about customer reaction to that. He should be. If customers see they are paying 75 bps for investment management (assuming fund managers reduce their fees by the amount they previously handed over to HL and others), they may balk at paying a similar amount for portfolio administration.

Does any of this matter much? Why obsess over a few basis points? Because controlling costs is crucial to investment returns, and those basis points add up to a significant sum over the years. A low cost fund is bound to return more than a high cost one, unless the latter is run by a manager able to add enough value to outweigh the additional cost.

There are such managers, but there is plenty of evidence they are few and far between, and hard to identify in advance.

Research in 2010 by Morningstar, a provider of fund data and analysis, found that expense ratios of funds were “the most dependable predictor of performance”. In every time period and data point tested, low cost funds beat high cost funds.

The debate has moved on since then to consider the hidden costs of investing as well as the explicit annual management charge on funds.

In a paper to be published in the Financial Analysts Journal, John Bogle, founder of the Vanguard mutual fund group, estimates the all-in costs paid by investors in actively managed US funds (including portfolio turnover expenses, sales loads and fees to investment advisers) come to 2.25 per cent.

Compounding these costs over an investment lifetime of 50 years means an initial investment of $10,000 would grow to around $100,000 (based on a 7 per cent return before costs, 4.75 per cent net), he says. Whereas, “at a cost of 0.06 per cent (easily obtainable in a low cost all-market index fund), the return would be 6.94 per cent and the final value about $286,000”.

Low cost funds are generally passive index trackers, so the debate about costs is usually couched in terms of whether active investment management is worth paying for. Investors appear increasingly convinced it is not, judging by the growing flows into ETFs and other index trackers in recent years.

This is more of a US phenomenon than a European or Asian one, largely because of the “Vanguard” effect. The US-based group, the world’s fourth-largest asset manager, invented index trackers and has long acted as a strong competitive force in the US industry. It levies an average expense ratio on its funds of 0.19 per cent, compared with a US industry average of 1.11 per cent.

The manager has brought its model to Europe, but its progress has been hampered by the financial advisers, banks and fund platforms that act as the middlemen between investors and fund managers. They demand half or more of the annual fund fee as compensation for selling funds, where they are still allowed to do so. ETF and index fund providers often will not pay up so their funds do not get sold.

The tables are stacked against individual investors when it comes to minimising investment costs. Shame we do not all have access to a scheme like the US Thrift Savings Plan, a pension plan for federal employees. Annual expense ratios for the (passive) funds available under the plan have varied since 2007 between 1.5 and 2.7 basis points. Sounds about right.