How do you calculate the total cost an investor pays?
In the third article in this six-part series on the cost of investing, we look at the challenge involved in working out the total figure an investor pays.
I often wonder what would happen if investors were sent a bill each month for how much they’re paying each money to have their money managed.
On opening the first bill, would they think it steep? Would they start exploring options for getting the bill down for future months? I suspect, for most people, the answer to both of those questions would be Yes.
Significant household expense
Asset management, even excluding the cost of advice, is a significant household expense. Yet because they don’t see how much we’re actually paying in pounds and pence, very few investors stop to question it. As long as the size of their retirement pot increases as the years go by, they have no reason to believe that they aren’t receiving value for money.
The truth is that investment returns are mainly driven by the financial markets, not by skill or expertise. In many cases, fund managers and other intermediaries are extracting value from the investment process rather than adding it.
The OCF is only part of the story
The problem is that working out the total amount an investor pays is extremely difficult.
The first thing to realise is that the explicit cost, effectively the ongoing charges figure (or OCF), is only part of the story. Underneath are a whole range of implicit costs — transaction charges, custody charges, brokerage fees, foreign exchange fees and so on — some of which are very hard to identify.
More than a decade ago, Chris Sier from Newcastle Business School started to look into the true cost of asset management. The very first product he investigated was a simple equity ISA, and yet he found no fewer than 16 layers of intermediation.
“That’s 16 companies sitting between you and investing your money,” Sier told BBC Radio 4’s Money Box in December. “Every one of those companies takes a piece of the pie as it passes through.”
Dr Sier was so appalled at what he found that he started to ask asset management companies for more information. “When I asked for it,” he told Money Box, “the rebuttal I had initially was, Don’t ask, you are damaging a fragile savings culture. They weren’t happy with me at all.”
Non-compliance with MiFID II
In theory, calculating the cost of investing should be very much easier now. Since the start of 2018, asset managers in the UK and the rest of Europe have been required to provide a figure for total fees and charges, and not just an OCF, under the EU directive MiFID II.
In practice, however, as Alan and Gina Miller from the True and Fair Campaign have demonstrated, many firms have failed to fall into line. To add insult to injury for investors, the Financial Conduct Authority has yet to get tough with firms that haven’t fully complied.
Investors pay up to four times the OCF
Undeterred by the industry’s reluctance to come clean over the full extent of fees and charges, the Lang Cat, an Edinburgh-based consultancy, has tried to come up with a more accurate picture of what investors are paying.
It found that many investors were paying almost double the OCF in the UK’s most popular funds once transaction costs are included. That could rise to up to four times OCF if implicit costs were included.
The OCF for the Janus Henderson UK Absolute Return fund, for example, was 1.06% a year. But when platform and performance fees were factored in, the total cost of investing jumped to an average of 3.82% if purchased via Hargreaves Lansdown.
Index funds, of course, incur lower transaction costs, but even trackers are considerably more expensive than the OCF when all costs are included. The Lang Cat found, for instance, that the BlackRock iShares FTSE All Stocks Gilt tracker fund had a total cost of 75 basis points — nearly four times its OCF of 0.20%.
The onus is on advisers
So where does all this leave advisers?
Make no mistake: fees and charges are substantive, they severely impact returns, and they vary hugely. Cost is also, as research by Morningstar has shown, the most reliable predictor of future fund performance. As a fiduciary, it is therefore essential than an adviser knows exactly what their clients are paying.
Yes, it’s still a minefield. Because different funds are using different methodologies for calculating costs, weighing them up can be like comparing apples with oranges. There is also bound to be an element of guesswork; for example, you can’t know, in advance how frequently a particular fund manager is going to trade. That said, there is far more cost-related information available now than there has been in the past. The onus is on advisers to find it.
Remember, the law requires asset managers to be completely up front with you about the the cost of investing. If they aren’t, or if they can’t explain their fees and charges clearly enough for you as an adviser to understand, you owe it to your client to choose a different provider.
If you missed the first two articles in this series, you can catch up here: