Hidden Costs of Investment
Passives and Index Trackers are vastly cheaper than Active Funds. It is not just a question of the Total Expense Ratios but also the cost of turnover.
Take the UK All Companies Sector as an example. Most actively managed funds have an Annual Management Charge of 1.5% pa. In addition they have other expenses declared of typically another 0.1% to 0.2% pa. Let’s be nice to them and say, on average, the combination known as the Total Expense Ratio (TER) amounts to say 1.6% pa.
Compare this with say Fidelity Money Builder UK Index Tracker with an AMC of 0.1% and a total TER 0.28% pa. Before even considering portfolio turnover costs the average Actively Managed fund has to deliver a further 1.3% or so per annum without taking any more risk than the index as a whole in order to simply match a tracker. Of course, there is no point in paying extra simply to break even with what you would have got if you just tracked the index.
Let’s now look at Portfolio Turnover Rates (PTR). These describe the proportion of the fund that has been turned over due to sales and purchases and is calculated according to a formula prescribed by the FSA. It is now a requirement for these to be published for UK unit trusts and OEICs within the Simplified Prospectus. You still have to hunt around for these figures as they are often quoted separately to other cost data. I am collating details of these prospectuses and will publish links in due course.
In the FSA Occasional Paper on the Cost of Retail Investments http://www.fsa.gov.uk/pubs/occpapers/OP06.pdf and, in particular on page 28, the average cost of a deal in a UK fund has been estimated at 180 basis points (1.8% to you and me). To find the cost of turnover you have to multiply the above cost by the PTR.
If you take the average PTR of an Active UK fund of 70%-90% (page 47 of the FSA paper) you end up with costs in addition to the TER of between 1.26% and 1.62%. If you take the Fidelity Special Situations Fund PTR of 137% you get an overall portfolio turnover cost of 2.46%. Quite a few active funds have PTRs of over 200%.
To get the total annual cost you have to add the PTR cost to the TER. This means that the actual annual cost of the average Active UK Fund amounts to between 2.86% and 3.22%. In the case of the Fidelity Special situations Fund you get total annual fund costs of 3.96% pa.
Contrast this with some trackers. The F&C FT All Share Index Tracker has a PTR of 0% and a TER of 0.39% and the Fidelity Money Builder with a TER of 0.28% and a PTR of -2.3%. These mean that the average active fund has to outperform them without taking any more risk by up to 2.94% per annum.
The sad truth is that most active funds can’t even achieve index levels of returns let alone beat them. So, why would you pay extra for that?