By BRENT SHEATHER*
Picture two petrol stations - one has petrol at 50c a litre, the other charges $1 a litre, yet the second is busier than the first despite its petrol being twice the price.
Irrational? Yes, but that is often the way things are in the world of fund management, where the price of essentially the same investment management can vary enormously.
Ignorance is one of the reasons why. And, as we shall see, simply working out the cost of management is difficult with some funds.
Managed funds with low fees obviously can't pay for so much TV advertising, but investment costs have also been the subject of a something of a dirty-tricks campaign for a long time. Some fund managers have insisted that costs don't matter, and that one should focus on the after-cost returns.
Investors may also have been seduced by the psychology of pricing - the more something costs, the better we expect it to be.
In the case of investment management, that is dead wrong; recent studies in the US by Standard and Poor's and Morningstar, leading providers of financial information and investment research, looked at the performance of a wide range of US mutual funds (unit trusts) and found that those with high expenses performed poorly on average. Not only does the price of investment management vary, it is also frequently true that the same fund manager will offer management of the same types of assets for very different prices - doing it one way will cost, say, 1.5 per cent a year, while using another structure will cost only 0.5 per cent.
And don't expect your friendly financial adviser to seek out the fund with the lowest expenses. He or she may receive part of your annual fees from the fund manager by way of trailing fees, trips overseas for achieving certain volumes of business and regular sponsorship of conferences at exotic locations. One of the reasons so many financial advisers ignore index funds is because they don't pay trailing fees.
If you're the sort of person who shops around for the best buys at the petrol pump or supermarket, then a focus on minimizing management fees will make sense and save you a lot more money.
A fund's annual operating costs yields useful information about its potential performance.
But despite their importance, investment costs often get the least attention from managed fund researchers who instead focus on historic performance, investment style and nebulous areas like "investment process", whatever that is.
Historic performance is almost always of no use because past returns rarely indicate what the future holds, knowledge of a fund's style may be of academic interest but one never knows which style is going to be most appropriate in future, and there is always the chance that your investment manager will change his or her spots.
There are four main types of fee involved in the asset management industry: initial fees, annual fees payable to the fund manager, annual monitoring fees payable to your investment adviser, and transaction costs. If you invest through a mastertrust there will be another level of fees, too.
As always in the topsy-turvy world of finance, initial fees are the least intrusive yet attract the most attention, while annual fees compound every year for as long as you own an investment but are often hidden away among the small print.
Initial fees can vary from as low as zero to as high as 5 per cent of the amount invested (and apparently even higher for some insurance products). Going for the zero option is not always best; some advisers will forgo their initial commission because the annual fees they get from the fund manager are so lucrative.
These are generally the single biggest fee you will pay and can vary from 0.2 per cent of the assets being managed each year, up to about 2.2 per cent, depending on the type of fund.
Bond (fixed interest) funds are generally less expensive than share funds, while stock exchange listed and index funds are most often cheaper than their unlisted cousins. Balanced funds usually have the highest annual fees.
But, just to keep you on your toes, some share funds have lower annual fees than some bond funds.
Managers disclose a fund's total annual fees - including management, custodial, trustee and ongoing administrative costs - in a single figure called the management expense ratio (MER).
Unfortunately, some New Zealand managers have decided that, as these costs are tax deductible, it might be more helpful to quote the after-tax MER. In other words, total costs less one third. In some investment statements the quoted MER, which has tax deducted, is less than the management fee alone, which is quoted before tax.
As well as being confusing, this is a bit deceptive; always insist on being told what the MER is before tax.
This area really is a dog's breakfast and needs to be tidied.
Further complicating matters is the fact that mastertrusts, which are popular at present, often have another one or two additional annual fees which, while disclosed, are often hidden away in obscure parts of the documentation when they should be added together and presented prominently with the MER.
Mastertrusts are occasionally able to negotiate lower fees with fund managers but these are rarely the lowest in the sector and any savings are usually more than offset by the mastertrust administration charges.
Annual Monitoring/Custodial Fees:
A monitoring fee is usually payable if you want your adviser to report regularly on how your portfolio is performing and give advice on whether changes are necessary.
A custodial fee is payable if you want someone to hold the securities for you and handle the paperwork. These fees also vary quite widely but together they seem to average out at between 0.5 per cent and 1.5 per cent of the assets under management. Recently one fund manager has begun offering a performance-based monitoring fee under which they receive a base fee of 0.5 per cent a year plus 10 per cent of whatever return your portfolio achieves. One worry with this system is that advisers will put more of your investments into risky sectors like shares to maximise their earnings.
Buying or selling investments costs money. These costs include brokerage, commissions, stamp duty and the market impact - the extent to which the price of a security is pushed up or down by a large buy or sell order.
Active fund managers generally turn over about 40 to 50 per cent of their portfolios each year, compared with less than 10 per cent for an index manager.
This turnover adds annual transaction costs of 0.4 to 0.7 per cent of funds under management according to research by Vanguard, the second largest fund manager in the US.
Once all these annual fees are added together you can compare them with the pre-tax returns you can expect from a diversified portfolio, to see how costs will affect returns.
Fund management expense ratio, say 1.6 per cent.
Monitoring/custodial fee, say 1 per cent.
Transaction costs, say 0.5 per cent.
TOTAL 3.1 per cent.
The average pension fund and balanced unit trust has around 40 per cent of its investments in bonds, 10 per cent in property and 50 per cent in shares. Bond yields, locally and overseas, average around 6 per cent. When it comes to shares, various experts such as Warren Buffett, the Economist magazine and the London Financial Times reckon the stockmarket will return about 8 per cent a year over the next 20 years. Assuming property does as well as shares, our typical portfolio will return 7.2 per cent a year, before tax, before fees and before inflation.
Subtract annual fees of 3.1 per cent and the investor is left with only 4.1 per cent, showing how important fees are when returns are low.
One rather disconcerting side-effect of low returns, coupled with high fees, is that investment advisers are tempted to push their clients' portfolios into riskier territory.
Owning too many shares in a bear market is not a pleasant experience, with new investors prone to becoming disillusioned. This may explain their tendency to sell at the bottom of the market.
* Brent Sheather is a Whakatane investment adviser.
By BRENT SHEATHER*