More scrutiny for investment costs

More scrutiny for investment costs

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After being a fairly well kept secret for decades, the costs of investing are rarely out of the headlines these days, which is undoubtedly a good thing for investors.

The latest body to weigh in on the subject is the European Securities and Markets Authority (ESMA), the regulator behind the MiFID II regulations which came into force at the start of 2018. ESMA’s first Annual Statistical Report into the performance and costs of retail investment products in the European Union has just been published and has some interesting, if unsurprising, findings on the impact of the costs paid by investors.

Despite the inevitable challenges inherent in comparing data across multiple countries with their own individual practices and regulatory environments, ESMA was able to extract some conclusions. These include:

  1. While gross investment returns vary in line with the underlying assets (unsurprisingly), costs tend to be fairly stable over time.
  2. Average costs for retail equity funds were 2%, compared to 1-1.2% for bond funds. For institutional funds, the equivalents were 1%, and 0.6% although most institutional funds are generally unavailable to private investors.
  3. Passively managed (index) equity funds account for only around 10% of EU equity fund value, although this is substantially higher than it was in 2008.
  4. Although the average returns of actively managed funds were slightly higher than those of passive funds before charges, they were lower after costs. Given that the report shows actively managed funds to have generally higher costs, this is consistent with what might be expected as addressed in Nobel laureate William Sharpe’s short and very readable 1991 paper.

Cost is important because it is one of the few variables over which investors have any control. Although performance can easily swamp costs, it is highly unpredictable and decades of research have failed to find reliable evidence that it persists. The UK’s Financial Conduct Authority found evidence only of the persistence of poor performance in its 2017 report. However, as ESMA confirms, costs do tend to be persistent from year to year. They therefore constitute one of the more useful criteria that can be used during the fund selection process. While they cannot directly negotiate with the fund provider, investors can vote with their cash and elect to hold their assets in funds and portfolios where the costs are lower and it appears that in the US at least, this has been happening for several years, both in the retail and institutional markets. The trend is seen in this 2018 Morningstar report.

Admittedly, a cost of say 2% (the average cost of an equity fund in the EU) may not sound like a large number but if the returns on the underlying assets are only 8%, costs are accounting for a quarter of the return. This is exactly what ESMA reports was the case in 2015-17 for equity funds. If returns are 4%, half the return goes in costs and the result may not be far from that of much less risky assets such as cash. Although bond funds tend to have lower costs, their returns are also lower (risk and return being related) and between 2008 and 2017, it reveals that the impact of those costs consumed 52% on average of the gross return.

Source: Bloomsbury Wealth

Of course it has not always been easy to know what the charges actually were. For many years only the initial charge and annual management charge (AMC) were published, the former often being heavily discounted despite (or maybe because of) the fact that over the long term, it had very little impact on the end result. Most of the impact on the terminal value of a long term (more than 10 years) investment is from the compounding of annual costs, a finding confirmed by the ESMA report.

However, the AMC only recorded the payment made to the fund management company for managing the fund. This is typically the largest single annual cost but is not by any means the whole story.

Then when the total expense ratio (TER) was introduced, those who wished to understand the costs they were paying had an additional source of information. The TER (which, despite its name, was nether total or a ratio) included assorted other costs charged to a fund, such as those for the depositary and custodian, regulatory, audit and legal fees and distribution. Just as people were getting the hang of the misnamed TER, it became the ongoing charges figure (OCF), which was at least better terminology.

The missing component in all this was the one which is the hardest to calculate. This is the impact of trading the underlying assets within the portfolio, both purchases and disposals. A fund will trade both in pursuit of the management strategy it pursues but also to cater for inflows and outflows of cash from and to investors. The former is voluntary but the latter is not – the manager has to provide liquidity for investors leaving the fund and those joining legitimately expect their money to be invested given that they are paying for it to be managed.

After attempts by several lobbyists to make transaction costs more available, one of the requirements of MiFID II was that they be provided to investors along with the explicit ongoing charges. Consequently cost data now has to be provided both before an investment is made (as an estimate) and annually in arrears. The latter shows the actual costs paid by the portfolio over the previous year. The exercise has involved the institutions involved in considerable work to produce the data in the prescribed format (it has to take account of any changes in the portfolio, which could potentially happen on a daily basis) but investors who had money invested in 2018 will shortly be receiving their first example of the report of the actual charges they paid. It will be interesting to see how many of them read and understand it and then how many take action over its contents.

One thing is clear – investment costs are under scrutiny to a greater degree than ever before and that should be a good thing for investors whose money is entrusted to those firms which manage it. If you live in the EU and don’t know what your investments are costing you, you soon will.