As of the 31st December 2012, commission paid out on investment and pension products was officially banned in the UK, through the advent of the Retail Distribution Review (RDR). This has meant that any new investment or pension advice has had to be conducted on a fee basis only.
Coupled with this, the Financial Conduct Authority has put in place a ban on ‘bundled’ rebates passing from fund managers to third party providers due to come into force in 2016. This will complete the circle with existing investments needing to be moved to a clear and transparent fee basis.
The benefits of fee over commission was espoused for many a month in the run up to the RDR implementation date. As a result, the various fee structures and levels of fee that an adviser can take have also been scrutinised. However, the recent discussions I have had with new clients has highlighted the lack of understanding as to how this fits in with the total cost of ownership involved in a portfolio.
Fund Total Expense Ratio (TER)
When you buy units in a fund, you pass your money to a fund manager who invests it in line with a set remit (for example, to achieve capital growth through investing in companies that are listed on the major UK stock exchanges.) In return for fulfilling this remit (hopefully) the fund manager charges an Annual Management Charge (AMC).
These fees can differ greatly depending on the approach of that particular fund. Actively managed funds as a group have an average TER of 1.66% (i) per annum (pa); however, these can be as high as 5% (ii) pa. When you compare this to passive UK equity funds which have TER’s as low as 0.15% pa, there is a huge difference.
The higher the TER, the higher the hurdle a fund manager has to clear before adding any value. When you factor in the weight of evidence against stock picking and market timing, this can mean that the TER may becomes a huge drag on performance.
Unfortunately the TER does not tell the whole story. There are a number of hidden costs that can add up to an even higher hurdle. These can include trading commissions and taxes, bid/offer spread (the difference between buying and selling prices) and market impact costs.
Various studies have been made into this opaque area. One of the most reputable ‘The Price of Retail Investing in the UK’ (iii), was published by the Financial Services Authority on the cost of investing in the UK. They found that the round cost of buying and selling a share in the UK could amount to 1.80%. Thus, if a fund had a portfolio turnover of 100% (they effectively replaced all holdings in their portfolio) it would add 1.80% to their TER.
More recently, a study was conducted that estimated active UK equity funds incurred additional costs of 0.97% per annum (iv). Even if we take the lower figure, this means the average UK equity fund is likely to cost investors 2.63% per annum. This, although a small number, can make a huge difference.
A tendency that is gathering pace in the UK is the use of wrap platforms and fund supermarkets as custodians by IFA’s, wealth managers and financial planners. Using them can bring a number of benefits such as reduced administration, open architecture access to investments, online access and economies of scale. However, they do add a layer of charges. The good news is that the economies of scale they can achieve often offsets their charge. For example, often a large platform can negotiate a saving of around 0.75% per annum on UK equity funds in return for a charge of between 0.25% and 0.50% per annum. However, it is worth considering any other charges that a platform may levy such as transaction fees and report fees.
If you are using a good adviser, they should be looking at these charges and balancing them against financial strength, efficient administration and other such factors that are important when choosing a custodian.
An often overlooked cost is the fees involved with putting your money into a tax efficient wrapper such as an ISA, investment bond or pension. These have additional layers of charges, however, should be kept to a minimum where possible. These can be expressed as a fixed amount or a percentage. Where the investments available are on an open architecture platform, the wrapper becomes commoditised so should be kept as cheap as possible.
Your adviser will levy a fee for advising you. This can range from 0.50% per annum to 1.50% per annum. It is important to understand what is included within your annual fee payment to your adviser. For instance, where they recommend a change to your portfolio, do your annual fees cover this or does your adviser charge transaction fees to make the change? Are you limited to a number of meetings? Do they include ongoing financial planning in this figure? Do you get a structured proactive service?
There are so many possibilities, both good value and poor value that it is important to understand exactly what is and isn’t covered within your adviser’s ongoing fee. Only then can you make a judgement call as to whether or not you receive value for money, whether you should pay a lower or higher adviser fee.
Total Cost of Ownership
When you add all of these costs together, you establish your total cost of ownership. To illustrate how this works, I have created two fictitious clients each with a portfolio of £500,000. Client A is invested in an actively managed portfolio with an adviser who charges 0.5% per annum; whilst client B is invested in a low cost passively managed portfolio with an adviser who charges 1.0% per annum. Without looking into the total cost, it may seem that client A is paying much less than client B. However the figures tell a different story…
Client A Client B
Portfolio Size £500,000 £500,000
Funds TER 0.91% * 0.35%
Hidden Charges 0.97% 0.10%
Custodian Fees 0.30% 0.30%
Wrapper Charges £150 £150
Adviser Fee 0.50% 1.00%
Total Cost of Ownership £13,550 pa or 2.71% pa £8,900 pa or 1.78% pa
* 1.66% reduced by 0.75% due to platform deals
At face value, without the above information, an investor may choose the adviser client A uses, as they charge half of client B’s adviser. However, even though client B pays his/her adviser a lot more than client A, client B pays an overall charge that is 0.93% lower than client A (equating to £4,650 lower). As the portfolio grows, this will result in a larger monetary difference over time.
Obviously, charges only tell part of the story. It is important to consider the other added value benefits that either client may be receiving from his/her adviser on an ongoing basis. Whatever your adviser charges you, whether it be 0.5% or 1.0% per annum, he or she should be adding value for their fee. However, by enjoying a lower charge, client B has a lower hurdle to surmount before experiencing positive gains and, in theory, achieving his/her goals.
The above example shows why it is so important to understand the total cost of a portfolio, not just the headline adviser charge. When reviewing a new or existing adviser, it is important to find out what value they will deliver for their, as well as what you are likely to pay (or are paying) for every aspect of your portfolio, not just focusing on comparing adviser charges. Your adviser should be able to give you details of all the above charges (hidden charges are more difficult to pin down). If they can’t provide these details, it may be time to appoint a new adviser who can.
(i) Moisson E & Kreider J (2009), Fund Expenses: A Transatlantic Study
(ii) Morningstar search conducted on 2 July 2013
(iii) James K (2005), The Price of Retail Investing in the UK
(iv) Miller A & Miller G (2012), Promoting Trust and Transparency in the UK Investment Industry