Q. When does the word “total” not mean “total”?
A. When used by the fund management industry in the term “Total Expense Ratio” (TER). As an investor in a fund you might reasonably expect the TER to express the entire cost of investing in that fund. Sadly, although the TER does include the annual management fee paid to the fund manager and any share of this paid as commission to an adviser, auditors fees, legal fees, and custodian fees, it does not include the cost associated with the trading that takes place within the fund. An academic study(1) suggests that the cost of trading in the average US mutual fund is actually higher than the published TER.
In the UK, a paper(2) by Kevin James of the Financial Services Authority backs this up, stating that trading adds 1.8% a year to the cost of a fund which turns over its entire portfolio in any given year.
With TERs on actively managed equity funds averaging 1.6% per annum, this makes the true total cost of investing in excess of 3% a year for many investors. In the current climate, a cost hurdle of 3% a year makes it very difficult for any fund manager, no matter how skilled, to make more than the broad market in which he or she invests. This is one of the reasons Carbon does not use actively managed funds.
To establish the trading costs within funds, we start with the Portfolio Turnover Rate (PTR). This is a measure of how much trading is taking place within a fund. The fund industry tries to confuse matters even more by having two definitions of what constitutes full portfolio turnover, i.e. changing the entire portfolio in any given year.
In the US, the Securities and Exchange Commission stipulates that a PTR of 100% means that the entire portfolio has been changed in the last 12 months. In the UK, European legislation means that the official definition of full portfolio turnover is denoted as 200%, i.e. 100% sales and 100% purchases.
Currently fund management groups publish the PTRs of their funds and the method they have used to calculate them in the Simplified Prospectus each year. Despite the fact that the industry readily acknowledges that consumer trust has been diminished by a lack of transparency, we find it curious in the extreme that the requirement to publish PTRs will disappear completely from July 2012 as a result of the introduction of a new document which will replace the Simplified Prospectus. What possible motive could there be for such a move?
Ultimately, whether this information is published or not, investors in an average actively managed fund will still have to overcome the significant hurdle associated with high levels of trading.
Fortunately, there is an alternative. Carbon only invests in institutional funds which have lower costs than their retail equivalents because they don’t pay any commission. Carbon only uses funds with very low turnover rates which reduces the cost of investing still further. Eliminating even 1% a year from the running cost of your portfolio makes a massive difference for a long term investor.
For more details, contact Barry O’Neill on firstname.lastname@example.org or 07971 912545.
(1) “Scale effects in mutual fund performance: The role of trading costs” Edelen, Evans & Kadlec, March 2007.
(2) “The price of retail investing in the UK”, Occasional Paper 06 by Kevin R James, FSA, Feb 2000.