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The hidden cost of fund investing

Investment | Unit Trusts

By Justin Modray, published 24 June 2011.
Helpful? 34

When a fund you own buys and sells shares you foot the cost, but these aren't included in any of the usual quoted charges. Should you be concerned?

If you've looked around this site you might have noticed that I usually hark on about total expense ratios (TERs) whenever mentioning fund charges. TERs are important, as they include not only a fund's annual management charge, but also running costs such as custodian and auditor fees which typically add 0.1% - 0.3% to annual charges.

However, TERs omit something that can have a far greater impact on overall annual costs - trading costs.

When a fund manager buys and sells shares the fund has to pay stamp duty and stockbroker commission, just like the rest of us. There'll also be a difference between the buying and selling price of the shares (a bid/offer spread) and a potential impact on the price of the shares if the manager is buying/selling a large amount - e.g. if the manager sells a large holding then dumping the shares on the market might reduce the price the manager can get.

Putting all these costs together, the total cost of selling shares in one company and buying some in another (i.e. a 'round trade') is likely to be around 1%.

ItemTypical Cost
Stockbroker commission 0.1% x 2 = 0.2%
Stamp duty (on purchases only) 0.5%
Bid/offer spread 0.15% x 2 = 0.3%
Price impact 0.05% x 2 = 0.1%
Total 1.1%

The bid/offer spread and price impact is likely to be higher for smaller companies/less traded shares, potentially pushing the cost of a round trade to over 2%.

Given these are charges we'd pay to pay if buying and selling shares ourselves, should we be bothered? It all depends on the extent a fund manager trades and whether these trades make profits that more than outweigh the costs of doing so.

Check the portfolio turnover rate

The extent a manager trades is referred to a the annual 'portfolio turnover rate' (PTR). A PTR of 100% means the manager has effectively changed all the shares in the fund once over the year. A 25% PTR means a quarter of the fund has been changed once while a 200% PTR means all the fund has been changed twice.

Tracker funds tend to have lower PTRs than actively managed funds, although this depends on the index being tracked - indices with frequent re-weightings and changing constituents will have higher PTRs. For example, FTSE 100 tracker PTRs are typically in the 15%-20% range whereas FTSE 250 tracker PTRs are often over 50%.

By contrast, actively managed funds tend to have PTRs ranging from 50% to over 300%.

How do you find out a fund's PTR? Fund groups seldom publish these figures on factsheets, so you'll need to take a look at the fund's simplified prospectus. Schroders is better than most and publishes all their PTRs in a single list.

PTR figures are obviously historical and a fund will likely vary in future, but if a particular manager has a consistently high or low PTR, chances are they will in future too.

Does the manager profit from changing shares?

A high PTR is no bad thing if the manager profits from the trades. For example, the Blackrock European Dynamic fund has a PTR of 716% over the last year, probably dragging performance by around 7% due to dealing costs, yet it still comfortably beat the FTSE Europe (ex UK) Index by about 10%. Yes, the manager traded a lot, but it appears to have paid off.

But unsuccessful managers who trade a lot simply rub salt into investors' wounds - the UBS Equity Income fund had a PTR of 461% last year but remains a perennial underperformer.

Conclusion

Dealing costs are a worthwhile consideration when buying funds, but I don't think they should dictate your choice. As ever with costs, if a manager has the ability to outweigh charges with decent performance then there's little to worry about (albeit I do resent paying high charges!). But if you buy into a manager who tends to have a high PTR then just beware that it increases the potential for losses if the manager gets it wrong.

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Readers' Comments (3) - To post a comment please register or login .


Comment by rbjones at 10:44am on 27 Jun 2011:

Thks Justin your work is always useful and much appreciated. My IFA just sacked me after protracted discussions over excessive charges!! Re your article I have often pondered the cost of buying and selling the underlying shares in a fund and concluded that for me its a bit of a red herring as I felt it was reflected in the quoted price of the fund and if the mgr does ok I dont really care how he achieves that. But I am interested in charges that detract from his quoted performance ie the TER that you have described. The charge I thought you were going to talk about is the spread on the buying/selling price of the fund. I think it used to be called the box when I was in the market. I think this is the funds latitude to bias the fund spread to discourage buyers or sellers when there are runs on the market in any particular direction. I believe the practice has been controlled more but i suspect monkey business still goes on. Particularly a share club I am a member of bought the SWIP US smaller Cos fund and the price we paid has pretty much never been seen before or since. I have to believe they were seeing a lot of buyers and biased the spread to the offer side or am I just seeing shadows. Regds


Comment by ivanopinion at 10:31am on 29 Jun 2011:

Interestingly, this is a point that is picked up by the index funds run by Dimensional. Rather than slavishly following an index, they make a point of trying to be a bit smarter about when they carry out trades. If the relative weighting of companies in an index changes, they might delay making trades if they think the prices are temporarily unfavourable. I presume the intention is that their PTR is lower than even other trackers.


Comment by justin at 10:42am on 11 Jul 2011:

rbjones, you're right to mention bid offer spreads.

I think what you're referring to is the extent a manager buys and sells units at the creation or cancellation price.

Creation price is the unit price including the cost of creating new units in the fund, i.e. the offer price of the underlying investments plus stamp duty and dealing costs.

Cancellation price is the price a manager will will pay when cancelling units, i.e. the bid price of the underlying ivestments less dealing costs.

The difference between the creation and cancellation price could be 1% or more and, when aded to any initial charges, makes up a unit trust's bid/offer spread. So if initial charge is 5% and the above 1% the bid/offer spread willbe 6%.

But you're right, managers can use 'box' management to determine whether you buy or sell at creation/cancellation price and/or make money themselves.

Suppose you sell units, the manager might give you the cancellation price. However, if they expect someone else to buy your units the manager could buy the units themselves and hold in a 'box' before selling on at creation price. Because the units have neither been cancelled or created (simply passed from one investor to another) the manager can profit from the difference.

Alternatively, the manager might llow buyers and sellers to trade at one price between the two (assuming they balance each other out, else units will physically have to created or cancelled). This is what happens with oeics, as they have a single buy/sell price rather than a bid offer spread.

Hope the above makes sense!