Category: TER

Top 10 Investment Guidelines

The media would have you believe that a successful investment experience comes from picking stocks, timing your entry and exit points, making accurate predictions and outguessing the market. Is there a better way?

It’s true that some people do get lucky by making bets on certain stocks and sectors or getting in or out at the right time or correctly guessing movements in interest rates or currencies. But depending on luck is simply not a sustainable strategy.

The alternative approach to investment may not sound as exciting, but is also a lot less work. It essentially means reducing as far as possible the influence of fortune, taking a long-term view and starting with your own needs and risk appetite.

Of course, risk can never be completely eliminated and there are no guarantees about anything in life. But you can increase your chances of a successful investment experience if you keep these 10 guidelines in mind:

Let the market work for you. Prices of securities in competitive financial markets represent the collective judgment of millions of investors based on current information. So, instead of second guessing the market, work with it.

Investment is not speculation. What is promoted in the media as investment is often just speculation. It’s about making short-term and concentrated bets. Few people succeed this way, particularly after you take fees into account.

Take a long-term view. Over time, capital markets provide a positive rate of return. As an investor risking your capital, you have a right to the share of that wealth. But keep in mind, the return is not there every day, month or year.

Consider the drivers of returns. Differences in returns are explained by certain dimensions identified by academic research as pervasive, persistent and robust. So it makes sense to build portfolios around these.

Practise smart diversification. A sound portfolio doesn’t just capture reliable sources of expected return. It reduces unnecessary risks like holding too few stocks, sectors or countries. Diversification helps to overcome that.

Avoid market timing. You never know which markets will be the best performers from year to year. Being well diversified means you’re positioned to capture the returns whenever and wherever they appear.

Manage your emotions. People who let their emotions dictate their decisions can end up buying at the top when greed is dominant and selling at the bottom when fear takes over. The alternative is to remain realistic.

Look beyond the headlines. The media is by necessity focused on the short term. This can give you a distorted impression of the market. Keep up with the news by all means, but you don’t have to act on it.

Keep costs low. Day to day moves in the market are temporary, but costs are permanent. Over time, they can put a real dent in your wealth plans. That’s why it makes sense to be mindful of fees and expenses.

Focus on what you can control. You have no control over the markets, but in consultation with advisor acting in your interests you can create a low-cost, diversified portfolio that matches your needs and risk tolerance.

That’s the whole story in a nutshell. Investment is really not that complicated. In fact, the more complicated that people make it sound the more you should be sceptical.

The truth is markets are so competitive that you can save yourself much time, trouble and expense by letting them work for you. That means structuring a portfolio across the broad dimensions of return, being mindful of cost and focusing on your own needs and circumstances, not what the media is trying to sell you.

Beware of the hidden risks of low-risk investing

Most investors recognize and understand the risks involved when investing. However, during times of extreme market decline, even the toughest investors’ risk tolerance is tested. Such dramatic downturns can force many to limit their risk exposure. But, regardless of market highs and lows, investors really need to maintain perspective and proper risk to pursue their long-term financial goals.

“Low risk” investments help protect one from a decline in the overall stock market, but might leave one exposed to other risks not seen on the surface.

Risk #1: Inflation cutting your real return
After subtracting taxes and inflation, the return one receives from a low-risk investment may not be enough to remain ahead of inflation.

Risk #2: Limiting your portfolio’s growth potential
Beware, some portfolios with low-risk investments may be riskier than one realizes due to the limited growth potential of these investments.

Risk #3: Your income can drop when interest rates drop
If interest rates have dropped by the time a low-risk investment becomes due, one might have to reinvest at a lower rate of return, resulting in a lower yield each month.

A properly constructed portfolio with the correct balance between risk and return will mitigate the risks of market volatility. When deciding on how to invest, it is important for investors to take into account their personal attitude to risk and capacity for loss but also to understand the performance characteristics of different blends of equities and bonds and in particular, how their own portfolio might behave. This will ensure that when markets perform in a particular way, investors will appreciate that this is within the range of possible outcomes for their portfolio.

This is where an independent financial adviser can help by guiding investors to the correct choice of portfolio, which has the best chance of helping them achieve their goals. They can also help educate investors so that they better understand what to expect and encourage them to adopt a disciplined approach.

Hidden Fund Costs could damage your investment performance

Most investors are aware that their funds levy annual charges against their funds. These comprise the Annual Management Charge which ranges from 0.1% to around 1.8% or more for UK mutual funds. In addition the funds are required to publish certain additional fund charges such as custody and legal costs. These two items make up the Total Expense Ratio (TER).

Many investors are unaware of the fact that, in addition to the TER, funds incur costs in two other ways. One of these, the Portfolio Turnover Rate (PTR), is caused by the costs which fund managers incur when the buy and sell stocks. The more they do this, the greater the PTR. In the UK the estimated cost of a sale and purchase is around 1.8%, when Stamp Duty is taken into account. The average UK fund turns over its portfolio by around 100% a year, thus adding around 1.8% onto investors’ costs. Many funds have PTRs of twice or more this level.

A further area in which investors can incur costs is the price at which funds are able to deal in their shares. Generally shares are offered for sale or purchase by market makers in batches of say, £250,000 or £1Million. On dealers’ screens the best priced batches are generally shown at the top of the list with prices getting worse further down the list. A fund needing to offload £10Million of a particular stock could therefore find its self selling via a number of market makers and not all at the best price available on the market. This can be a substantial hidden drag on fund performance, especially for very large funds or those which trade actively.

So what can be done about this? Bearing in mind that the method of access to the market (fund selction) is very much a secondary decision, well behind Asset Allocation, the optimum way to keep fund costs down is to invest in passive or tracker funds. These can be expected to provide returns in line with the performance of the market at low cost. In addition certain passive funds engage in dealing strategies designed to optimise the price at which deals are carried out.

Hidden Costs of Investment

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?