Investment Costs - the True Picture

By: Ray Prince

We are all aware of the saying that there are two things which you can't escape - death and taxes.

Well, we would add a third here, and that is COSTS.

When we speak to our many doctor and dentist clients, or indeed to new clients, they understand that when they make an investment, there will be associated costs.

We always ensure that these costs are explicit, and agreed with the client at outset as to what they are:

- What they pay us

- What they pay for administration

- What the fund costs are

If you had invested say ?100,000 yesterday, you would have these costs listed with an accompanying quotation called a Personal Illustration.

So thats ok then, its all there in print, and you are in possession of all the facts. If only it was as simple as that!

What clients are almost always unaware of however, is that there is a major "hidden" cost, that is not calculated within your illustration.

Regular readers of this newsletter will be aware that we favour 'passive/asset class' investment rather than 'active'.

What does this mean?

Well, an active fund manager is frequently buying and selling shares to get the best return he/she can. This of course means that if they, say, sells ?100,000 worth of Barclays shares and buys HSBC shares, there are costs involved in doing so.

(Studies in the US have concluded that the higher charges associated with portfolio turnover were not recovered by better performance***).

Over a given year the average manager will trade circa 70%# of the shares in their fund, meaning that by the end of the year if the fund owned 100 shares, only 30 would be unchanged. This percentage varies widely, and can be as high as 300% plus.

In a Financial Services Authority report called 'The Round Trip'*, the Portfolio Turnover Rate (PTR) were calculated at 1.8%, and similar costs apply around the world**.

So the above trades would typically cost the fund - and you - ?1,800.

A government commissioned report by Paul Myners estimates that these portfolio turnover charges costs UK investors ?2.5 billion each year!

These costs of course reduce your returns, and are termed 'Performance Drag'.

This means that it is common for many active funds to have explicit costs of say 2%, but also portfolio turnover costs of an extra 1-3%.

The Financial Tips Bottom Line:

As these charges can clearly eat into the returns on your investments the best course of action is to review your portfolio so that you know where you stand.

ACTION POINT

Look at your ISAs, PEPs, or Unit Trusts.

Find out what the portfolio turnover rate is - details can be found in the companies prospectus.

*Financial Services Authority (FSA) Occasional Paper 6

**Wilcox (1993) 1.2%, Carhart (1997) 0.95%, Orton (1999) 1%, James (2000) 1.3%

***Performance of Mutual Funds, J Chalmers, R Edelen & G Kadlec Nov 1999

# A typical passive fund for comparison would be nearer 7-8% pa PTR. This adds around 0.13% in trading costs.

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