The Case for Flat Fund Fees

Cost is often cited as the only certainty when it comes to investing - but with so many hidden variables, this is not the case for fund investors. Should we insist on flat fees?

Emma Wall 15 June, 2015 | 2:03PM
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All this week we are running a Guide to Active and Passive Investing to help you, the investor, make smart choices for your portfolio.

Predicting how much a fund investment costs – whether it is active or passive – is near impossible. While you may be quoted an annual management charge (AMC) on purchase this is simply a guide price, an expectation of the known costs.

What is not included in the price are trading costs, audit charges, legal costs, admin fees and even spurious additional charges. Add these on top of the AMC and you can often find the annual cost of investing doubles. Morningstar fund reports quote the ongoing charge (OGC), which includes admin charges but not trading costs – as they cannot be predicted.

These fees not only eat into returns, but it makes it difficult for the investor to compare like for like – two developed market equity funds with a similar process and performance for example may look similarly priced on the surface, but result in vastly different returns for the investor thanks to extra fees.

Unacceptable In Any Other Industry

The idea that you don’t know what an experience or product will cost before you agree to buy it seems ludicrous in any other circumstance. In a bar or restaurant you know how much the food and drink costs – and can even calculate the service charge before ordering. But imagine after you’d paid up, picked up your coat and headed for the door a waiter ran after you and demanded an extra £20. Word would get out on various reviewing websites, and the establishment would soon be deserted.

This is exactly happens in fund management, and yet, not enough investors are voting with their feet.

Why the Unpredictable Cost?

Investors get charged for fund managers turning over a portfolio. Some fund managers employ a long-term buy and hold strategy. Terry Smith of Fundsmith Equity for example actually had negative turnover last year thanks to inactivity on his part and flows into the fund.

Other managers such as Ian Heslop manager of the Old Mutual North American fund tweak their fund holdings on a regular basis to take advantage of style rotation in the market and pick up unloved stocks on the cheap. The ongoing charge on Heslop’s fund is currently 1.75% - high for a developed market equity fund, and trading costs are applied on top of that.

Even passive funds have turnover charges; when share price fluctuations affect the market cap weighting of a company in a certain index, passive funds have to trade to match the new weighting. When companies fall out of an index entirely – either through privatisation or they become too large or small for that particular index – they have to be sold by the index tracker or ETF.

What is the Right Cost?

Terry Smith launched Fundsmith in 2010 with a commitment to low turnover and low cost. He compared his approach to Ryanair saying: "Our ideal holding period is indefinite. Research shows that the average fund manager turns over his portfolio by 80pc a year, costing the fund 1.5% in dealing commissions and spreads."

There is some argument that with negative turnover the AMC should be even lower than 1%, as with so few purchases over the last year investors may question what they are paying him for, but at least Smith’s style means there will be fewer nasty surprises.

The current system of an annual management charge, topped up with additional charges unfairly biases those fund managers with a low-turnover. Discouraging fund managers from making trades which could be to benefit of the end investor would be foolish. While a buy-and-hold strategy works for some sectors it would be short-sighted to do the same in a fast moving emerging market. Take the effect of the recent drop in oil price on so many companies globally last year for example.

Flat Fees Mean No Surprises

Instead, there is a school of thought that advocates a single, flat fee for fund management. This would not have to be the same for all funds – investing in a liquid developed equity market does not cost the same as fixed income investing in Asia.

The fund manager would set the annual fee, whether it is 0.75%, 1% or 1.75% and however many trades are made, however many legal costs incurred, year in, year out that is all the investor would pay.

It would make it easier for the fund manager to know what they have to make each year to deliver a positive return and it would make it easier for the investor to compare funds. And it may go some way to building up trust which is so lacking currently between investors and fund management.

What Do the Analysts Say?

Chris Traulsen, Head of Fund Research EMEA for Morningstar, expresses doubts as to whether a flat fee structure would work for fund investment and instead called for firms to pass along economies of scale as they grew and reduced charges through time.

“With a mandated fee, I expect they’d start reasonably high to ensure a high profit for themselves and unless market pressure forced them to change, they would stay that way,” he said. “And if it’s a flat fee that can’t be changed, it might limit their ability to respond to competitive pressures and reduce the fee.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Fundsmith Equity R Acc5.34 GBP-2.59Rating
Jupiter Merian North Amer Eq L GBP Acc16.91 GBP-1.98Rating

About Author

Emma Wall  is former Senior International Editor for Morningstar