The activities undertaken by an active fund manager
normally result in higher annual management charges. This
is what you would expect as they must carry out more
research and analysis than a passive "manager". However,
what few clients fail to appreciate is, the buying and
selling of shares within a fund also incurs costs and these
subsequently impact detrimentally on performance.
This is known as the "performance drag".
A Financial Services Authority (FSA) report* authored by
Kevin James undertook to quantify the costs of trading to
determine the performance drag. He concluded that the cost
of a "round trip" trade in the UK was 1.8%. A "round trip"
is the selling of one company's shares and replacing them
with another for the same value. For example selling
£10,000 worth of Barclays' shares and replacing them by
buying £10,000 worth of HSBC shares.
Let's look at a breakdown of the costs:
- Commission 0.3%
- Bid/Offer Spread 0.75%
- Price Impact 0.25%
- Stamp Duty 0.5%
Major studies elsewhere in the world have concluded similar
results**. The headline figures were lower but they did not
include Stamp Duty as Stamp Duty is only payable on UK
shares.
A Government commissioned report into retail investments by
Paul Myners estimates that portfolio turnover costs UK
investors £2.5 billion each year. The UK has only recently
fallen into step with the rest of the world in making it
compulsory for fund managers to disclose their portfolio
turnover. This revealed that many of the best selling UK
funds have portfolio turnover rates of between 100% and
200%.
If the portfolio turnover rate of a UK fund was 100% this
would "cost" the client 1.8% in Performance Drag.
The impact of charges has never been more important in
arranging an investment portfolio. If the explicit annual
fund management charges are 2% and the implicit costs of
portfolio turnover is a further 2% then this means 4% is
being wasted in charges. Charges of this level were masked
by the double digit returns of the eighties and nineties
but as the stockmarket returns to its long term average,
losing 4% per annum will have a significant impact on the
actual returns clients receive.
In addition, studies in the US*** concluded that the higher
charges associated with portfolio turnover were not
recovered by better performance.
*Financial Services Authority (FSA) Occasional Paper 6<br>
**Wilcox (1993) 1.2%, Carhart (1997) 0.95%, Orton (1999)
1%, James (2000) 1.3%<br> ***Performance of Mutual Funds, J
Chalmers, R Edelen & G Kadlec Nov 1999<br> <br> The
Financial Tips Bottom Line
As you are probably not aware what the turnover rate is on
your investment funds, the easy reaction could be to simply
ignore it.
The good news is that the information IS available, and you
can get hold of it by contacting your fund provider(s) and
asking them. The details are normally contained in their
fund prospectus.
You'll then be able to see the additional costs levied,
which will help you decide how to invest your money in the
future.
----------------------------------------------------
Ray Prince is an Independent Financial Planner with
Rutherford Wilkinson plc, and helps UK Resident Doctors and
Dentists get the best deals on mortgages, protection and
investments, as well as helping them achieve their
financial objectives. Just visit
http://www.medicaldentalfs.com to get your free retirement
planning guide. Rutherford Wilkinson plc is authorised and
regulated by the Financial Services Authority.
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