One of the reasons why investors struggle to grasp quite how much they’re paying to invest is that the figures quoted seem deceptively puny.
Charges are usually expressed as a percentage, or sometimes as basis points. One basis point (or bip) is one-hundredth of one percent. Expressed like that, why would anyone begrudge paying a few basis points for someone to manage their money?
But those tiny-sounding bips represent an enormous transfer of wealth from the client to the fund manager and other third parties, which is wonderfully encapsulated in this anecdote from Jason’s Zweig’s The Devil’s Financial Dictionary:
“Our management fee is only 50 basis points,” said Phil D. Hopper, a portfolio manager at the investment firm of Tucker, Cash & Left in Grosse Point, Michigan. “That’s a bargain for the services we provide”. Asked why the licence plate on his Maserati in the firm’s parking lot read “50 BPS”, Mr. Hopper cleared his throat and replied, “That stands for 50 bauds per second, the speed of my first modem.”
It’s high time that bips and percentage points were given the boot. They serve the industry well, but they give consumers a grossly inaccurate impression of the total cost of investing.
Earlier this year, my colleagues and I at Sensible Investing TV worked out the impact of fees and charges on the long-term returns of a typical UK investor. We based our calculations on an investment of £100,000 over 40 years, and a annual management fee of 0.75% — i.e. 75 basis points — which is about the UK average for an actively managed fund.
Investors also pay a platform charge of around 0.35% and an average adviser charge of 0.82%. Initial adviser charges, annualised, come to 0.24%. Then there are fund custody and administration costs, which average 0.17%. On top of all that investors pay transaction costs. The problem is that these are a complete unknown and depend on how much trading your fund manager chooses to do, but the average is currently 0.41%.
Add those figures together and the total comes to 2.74%. Now, even that figure seems relatively modest, but remember, you pay that percentage each and every year, and regardless of whether the value of your portfolio goes up or down. When you factor in the effect of compounding over several decades, the overall impact can be huge.
Let’s assume an annualised return of 8% before charges which, after charges of 2.74% nets down to 5.26%. 40 years on, that means the £100,000 you invested would without any charges be worth £2,172,452, and after charges just £777,203. So your actual gain would be a mere £677,203. That’s because the effect of your total charges would have reduced your potential return by a staggering £1,395,249. In other words, more than two thirds of your potential gains are lost.
Which sounds better — an annual charge of 2.74% or a total bill of nearly £1.4 million? Now you can see why the industry doesn’t like talking in terms of pounds and pence.
The simple answer is to scrap bips and percentage points altogether. Almost every other industry you can think of presents us with a bill. Why should investment firms be any different?
In fact, why don’t regulators go one step further? Once a year, along with a total bill and a breakdown of exactly what they’re charging for, firms should also be made to specify — again in pounds and pence — how much value, after costs, they’ve actually added.
I suspect the vast majority of investors would be horrified. As a recent study by the Pensions Institute concluded, “the average UK equity mutual fund manager is unable to deliver outperformance net of fees”. That’s right — they extract value, rather than add it. Moreover, to quote the same study, “although a small group of ‘star’ fund managers appear to have sufficient skills to generate superior gross performance, they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors.”
If regulators and governments really are serious about putting consumers first, and protecting taxpayers from the cost of colossal state benefits to future retirees, this is precisely the sort of measure they should be considering. Alas, so powerful are the vested interests opposed to greater fee transparency that, in all probability, we’ll continue to be fobbed off with bips and percentages for many years to come.