Brent Sheather: Counting the cost of your investment

Picture two petrol stations.

One has petrol at $1 a litre, the other at $2 a litre, yet the latter is busier than the former despite its petrol being twice the price. Irrational yes, but that is often reality in the world of fund management. The price of essentially the same investment management can vary enormously in New Zealand, Britain and the United States.

Why? Ignorance is a big factor and just counting the costs of some funds is difficult.

Investment costs have also been the subject of something of a dirty-tricks campaign for a long time with even one fund manager of the year famously insisting that costs didn't matter.

Investors may also be seduced by the psychology of pricing - expecting better management - and higher returns - from the more expensive alternative. Unfortunately that is dead wrong: studies by Standard & Poor's and Morningstar in the US, leading providers of financial information and investment research, looked at a wide range of US mutual funds and found that those funds with high expense ratios on average performed poorly. The running costs of a fund are especially important because, in the investment world, fees are fact in a sea of unknowns, false truths and dead ends. As such they are the one variable which can generally be relied upon to differentiate fund managers over the long term.

Not only does the price of investment management vary in the market, it is frequently the case that the same fund manager will offer management of the same asset class via different instruments with one priced at, say, 1.5 per cent a year and 0.5 per cent for another. And don't expect your friendly financial adviser to seek out the fund with the lowest expense ratio - he or she may receive part of your annual fees from the fund manager by way of a trailing payment, trips overseas for achieving certain volumes of business and regular sponsorship of financial planning conferences at exotic locations. One of the main reasons retail investors have less exposure to low-cost index funds than institutions is because index funds don't pay trailing fees.

If you shop around for the best buys at the petrol pump or supermarket then a focus on minimising management fees will make sense too, and save you a lot more money. A fund's annual operating costs as represented by the management expense ratio is one of the few facts about a fund which actually yield useful information as regards future performance.

Despite its importance it often gets 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 in that past return is rarely indicative of that in the future. Knowledge of a fund's style may be of academic interest but one never knows which style is going to be most appropriate going forward 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 via a master fund there will be another level of fees here too.

Initial fees

As ever in the topsy-turvy world of finance initial fees are the least intrusive yet almost always attract the most attention. Initial fees can vary from as low as zero to as high as 5 per cent (or apparently even higher for some insurance products). Going for the zero initial fee option is almost always not the best deal: some intermediaries will forgo their entire initial commission because the annual fee payable to them by the fund manager is so lucrative.

Annual fund management fees

This is usually the single most significant fee because you pay it each year on the increasing value of your investment. Management fees can vary from 0.2 per cent a year of assets under management to about 2.2 per cent a year depending on the type of fund and its orientation. Bond 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. However, note that some share funds have lower annual fees than some bond funds. Fund managers disclose the total of a fund's annual fees including management, custodial, trustee and ongoing administrative costs in a single figure called the management expense ratio or MER for short. Unfortunately in New Zealand some fund managers have decided that as these costs are tax deductible it might be more helpful to quote the after-tax MER, ie total costs less one third. Consequently, although the management fee is only part of the MER in some investment statements the disclosed MER is actually lower than the management fee. This highly questionable practice doesn't do anything to help the industry's image of transparency. Always insist on being told what the pre-tax MER is. Further complicating matters is the fact that master funds, which are apparently 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. Master funds occasionally are able to negotiate wholesale fees with fund managers but, despite the advertising, these are rarely the lowest in the sector and any savings are usually more than offset by the master fund's own charges.

Monitoring/custodial fees

A monitoring fee is usually payable if you want your adviser to regularly report on how your portfolio is performing and give advice as to whether or not changes are necessary. A custodial fee is payable if you want someone to hold the securities for you and handle the paperwork. These fees vary widely but seem to average out at between 0.5 per cent and 1.5 per cent a year of the assets under management.

Transaction costs

These are the brokerage, commissions, stamp duty costs and market impact costs of buying or selling securities. Market impact refers to 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 have an annual portfolio turnover rate of 40-50 per cent compared to less than 10 per cent for an index manager. This turnover adds transaction costs of 0.4 per cent to 0.7 per cent a year of funds under management, according to research by the US's second largest fund manager, Vanguard.

Total annual fees are summarised in the table and add up to 3.2 per cent.

Getting to grips with the fees you are actually paying is only half the story - annual fees need to be put into perspective. If the stockmarket returns 20 per cent a year and bank rates are 6 per cent, who cares about a 3 per cent fee? So to get some perspective on the significance of fees we need to forecast the performance of a typical balanced portfolio.

The average NZ pension fund has an asset allocation of around 40 per cent bonds, 10 per cent property, 50 per cent shares. Bond yields locally and overseas average out at around 7 per cent and experts like Warren Buffett reckon the long term return of the sharemarket in the next 20 or so years will average no more than 8 per cent.

Assuming property does as well as shares and applying the 40/60 weighting gives a total portfolio return of 7.6 per cent pre-tax, pre-fees, pre-inflation. Subtracting annual fees of 3.2 per cent a year leaves only 4.4 per cent, showing how important fees are in a low return environment. The pie chart illustrates how the 7.6 per cent return is divided up.

One side-effect of a low return environment is that advisers are tempted to push clients' portfolios further out along the risk curve. High fees are bad enough but their real significance may be that Mum and Dad end up with high-risk portfolios.Brent Sheather is a Whakatane-based investment adviser

Annual fees

* Fund management expense ratio, say 1.6%
* Monitoring/custodial fee, say 1.0%
* Transaction costs, say 0.6%
* Total 3.2%