The true charges levied on investment funds are often hard to find.
Here on the Fool, we've long argued that investors should look hard at investment funds' Total Expense Ratios (TERs) before parting with their money. The logic? The dreaded Annual Management Charge (AMC), which has no standard industry definition, and which enables providers to tout a low AMC while actually charging investors a lot more.
But TER isn't everything. While it is subject to strict Financial Services Authority (FSA) rules on what can and can't be included, it doesn't include costs such as the Stamp Duty Reserve Tax (SDRT). This is payable whenever UK stocks are bought, and whenever the shares of a fund investing in UK stocks are redeemed and subsequently re‑issued.
Low-cost provider Vanguard, as I've written, has broken ranks with the rest of the industry by charging SDRT upfront. Their argument is that this is fairer for long-term buy-and-hold investors -- an argument that it's difficult to fault.
What's more, by breaking out SDRT and making it separately payable, they're also cannily improving the tracking errors for those of their funds which are affected by SDRT. And tracking error, of course, is another measure that investors would generally do well to compare before parting with their cash. A low-cost fund that tracks the index very poorly is no substitute for one which charges a little more, but replicates it perfectly.
So far, so familiar. But Vanguard have now upped the stakes, in two important regards.
Ban AMC-based marketing
First, in a hard-hitting statement, the company has expressed regret that so few providers make TERs easily available. In the documents where TER is supposed to be disclosed, it is of course duly disclosed. But generally, it's their more misleading AMCs that many tracker providers lead their pitch with.
"In the UK, the TER was supposed to have replaced the AMC, and we ought to be well on the way to having all-inclusive prices for investment products -- which is clearly not the case," says Peter Robertson, head of retail at Vanguard. "At present, TERs are confined to disclosure documentation and research papers, while the AMC is still what many people look for."
Needed: a better TER
But is the TER itself the right measure of investing cost? Not in its present form, says Vanguard.
Regulators and industry practitioners, points out Mr. Robertson, agree that the TER should exclude transaction costs. At first sight that seems odd: how can a measure be described as 'total' if something is excluded? The industry's standard rebuttal to this is simple: TER is about operating costs, while transaction costs are capital costs, and so will show up in the investment return, via the tracking error.
Yet in some EU member countries transaction costs are included in operating costs, and European regulators insist managers disclose their portfolio turnover rate (PTR) -- with turnover, of course, being directly proportional to transaction costs.
And the PTR can make a big difference, points out Mr. Robertson: "Some active funds have PTRs in excess of 300%, leading to clients paying 1.5% in SDRT each year, and resulting in a total cost of 3% each year when added to the TER. So taking an example of an investment of £10,000 with charges of 0.2% (a low turnover tracker) or 3% (a high turnover active fund) and compounding over 10 years with 6% growth, the tracker would be worth £17,553, while the active fund would be worth £13,206."
Yet another strike against active funds, in other words -- and a compelling illustration of why we all ought to be taking more notice of PTR.
So is there a way forward?
Vanguard likes to think so. Describing a measure as a 'total' cost of investing and then excluding significant elements of that cost makes no sense, charges Mr. Robertson. What's needed is a form of TER that includes transaction costs.
And, he points out, if you know the average transaction cost and multiply it by the turnover rate, you can easily calculate a revised, and more representative TER. "This is the direction in which we should be heading," he insists.
"Making clear the relationship between turnover and cost would not only tighten up TERs but might enable investors to save some tax," he adds. "At Vanguard, we believe that the AMC should be relegated to the small print, and that providers should only advertise TERs -- giving, ideally, the real price paid by the customer. We also believe that PTR should be refined to reflect manager-driven turnover, and thereby enable the calculation of an annual cost to the investor."
It's an interesting perspective, and one which also serves to soften the 'passive funds good; active funds bad' debate that -- in my opinion at least -- can often be an over-simplification too far.
But is it the right perspective? And will the industry buy into Vanguard's arguments? Tomorrow, I'll be looking at some hard research which sheds light on the issue, and talking to other industry insiders to gain their views.
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