Switching investments can be costly

By BRENT SHEATHER

Pick up an investment statement from any of the major unit trust managers and you will probably read that they have "no switching fees".

In other words, switching between different funds from the same manager will cost you nothing, at least for the first four or five switches a year.

Similarly, most of the mastertrusts used by financial planners also boast that switches between funds within the mastertrust can be done free of charge.

Sounds good, doesn't it? Free switching is a particularly significant feature - critical in the financial planning world - because moving from, say, a global share fund to a New Zealand share fund is typical of the transactions involved in the "rebalancing" or "tactical asset allocation" which financial planners perform quarterly to earn their monitoring fees.

But in a world where bonds are likely to earn 6 per cent a year and shares 8 per cent, an investor told that switching some of his or her bonds to global shares was going to cost 1 to 2 per cent in transaction costs would probably think again about the wisdom of the strategy.

Yet that is a lot closer to the actual costs incurred in that exchange than the zero promised in the investment statement. Fund managers and financial planners know that Mums and Dads are particularly averse to transaction costs. The obvious solution is not to disclose them or, better still, bill someone else for them.

Because these trading fees are not mentioned or disclosed, the implication is that you either don't pay for them or they are included as part of your management fee.

To understand this misrepresentation we need to get to grips with some basic facts about trading financial assets.

If Mr and Mrs Battler want to shift their money from, for example, a global equity fund to a New Zealand share fund, most times they need to employ an army of eager intermediaries: stockbrokers to deal in the shares, a custodian to take care of the paperwork and a bank to buy and sell the different currencies involved.

While millions of share and bond transactions occur every day, they are not frictionless, as we have been led to believe. Each movement costs and must be paid for.

For example, stockbrokers, while being generally agreeable fellows, will not buy and sell shares for you free of charge.

The trading infrastructure, including stock exchange expenses, custodial arrangements, research and the very cost of supplying liquidity to a market must all be paid for.

Why else would Guinness Peat Group buy shares in the New Zealand and London stock exchanges if it were not in the expectation of profits?

The second largest fund manager in the United States, Vanguard, reckons that even in the highly liquid New York Stock Exchange, the cost of a round trade - a buy and a sell - is about 1 per cent, and that routine turnover within a fund reduces returns by 0.6 per cent a year.

In Britain, the leading regulatory body, the Financial Services Authority (FSA), calculates that a round trip trade by an institution on the London Stock Exchange costs about 1.8 per cent. A large part of that expense is in the form of the "bid/offer spread", the difference between the price you get when you sell a share - or any other investment - and the higher price you pay when you are buying.

A report by the FSA refers to transaction costs as being "implicit" because, while they come out of your funds under management, unlike management fees they are not explicitly disclosed to unit holders.

The FSA also makes the point that the cost of trading becomes more significant as the market rate of return drops.

Switching from global equities to New Zealand shares takes on an entirely different perspective if one realises that it will cost one quarter of a year's return.

The interesting thing about these costs is that, as the fund managers' marketing material tells us, they can get bulk discounts on the brokerage and custodial side of things, but what they don't say is that it frequently costs more to deal in larger volumes in terms of the bid/offer spread and market impact.

Spreads, market impact and commissions are much greater in less liquid markets. Take a look at the quotes for shares in DB Breweries on the local exchange on Monday.

The buy quote was $7.25 with the sell quote of $7.95 - a spread of 9 per cent. That is unusually high, and a determined buyer would see some improvement, but even a 1 per cent spread is a big deal. Costs in illiquid markets like small companies (including some UK investment trusts), junk bonds, emerging markets and property are much, much higher.

So how can we reconcile these very real costs with statements that switching is "free"? In switching from global shares to New Zealand shares, for example, is it reasonable to expect that our friendly US broker - who reported record profits for the June quarter - will be happy to sell our portfolio of global shares at no brokerage, no bid/offer spread, with no market impact, convert these US dollars to kiwi dollars at no cost and then persuade a local stockbroker to buy New Zealand shares, also at no cost? Not likely, is it?

However, as with many financial matters, the free switching illusion is partly correct; if Mr and Mrs Battler switch from global shares to New Zealand shares they don't pay for the cost of that specific transaction - all the unit holders in the fund pay.

Conversely, when other people buy and sell, Mr and Mrs Battler pay for their transactions. So, even if you "buy and hold" you may be subsidising other people's trading.

What is worse is no one tells you how big these costs are or what the turnover is. But these costs are real and they are the reason that a paper published by Vanguard last month shows definitively that the greater a fund turns over its portfolio, the lower the return to unit holders.

Free switching doesn't exactly encourage "buy and hold" despite the advertisements telling us that is the way to get rich.

Vanguard recently closed its high-yield bond fund to new investors, partly because it judged that the transaction costs involved in investing the huge flow of new funds were going to be bad for existing unit holders. Such noble gestures are understandably rare.

So how do you avoid paying other people's transaction costs? It's not easy and, paradoxically, funds that offer "free switching" are likely to suffer the highest transaction charges. Investment trusts - which trade on the stockmarket, rather than being bought and sold from a manager - don't offer free switching but they can have horrendous bid/offer spreads in both New Zealand and Britain, and portfolio turnover within the fund can be high.

Probably the best bet is a buy-and-hold strategy with that old favourite, the index fund, as they generally don't offer free switching and turnover is usually much lower than it is for actively managed funds.

So when your financial planner suggests it is time to trade that biotech fund for property in Sydney, have a think about the process you are about to set in motion, what it is going to cost, and wonder who is going to pay for it.

* Brent Sheather is a Whakatane investment adviser.