John Greenwood gets under the skin of what is happening with fund manager research costs

8th March 2013

Is your fund firm charging you more for its services than it says it is? The sad fact is that when it comes to most providers, you have no way of knowing.

A fund you invest in may claim to have an annual management charge (AMC) of, say, 1.5 per cent, but the total cost of investing can be considerably more, in some cases up to 4 per cent a year once all the costs of trading have been taken into account.

It is fair enough that the cost of buying and selling shares does not come out of the money the fund managers deduct from your fund in charges. If market conditions dictate that a lot of buying and selling of shares is needed to protect your investment, it would not be fair on the fund manager to pay the costs of achieving that out of its own revenues. The fund manager doesn’t pocket this money – these costs include broker costs for buying and selling shares and stamp duty of 0.5 per cent of the value of UK share transactions which goes to HM Revenue & Customs.

Nor should the fund manager be responsible for footing the bill for audit and legal costs incurred in the management of the fund. These costs are also paid out of the investor’s cash. Add audit and legal costs to the fund manager’s AMC and you get another figure often quoted on investment fund documentation, the TER, which stands for total expense ratio.

Last summer Labour leader Ed Miliband had a pop at the financial services industry over hidden charges. He pointed to funds with total costs of investing of up to 4 per cent – a cue for lots of headlines about rip-off pension and investment charges in the newspapers.

Miliband’s intervention was poorly executed – the worst example of a high-charging fund he could find was the Neptune UK Mid Cap fund – a tiny fund by Square Mile standards, holding just £12m of assets. But it did have a total cost of investing of 3.96 per cent, despite publishing a TER of 2.5 per cent at the time.

Miliband’s case wasn’t helped by the fact that he had chosen as his example of bad industry practice a fund that had excelled beyond most of its peers, delivering to investors a return of 94 per cent over three years and placing it first out of 288 funds in its sector over that period.

But however cack-handedly he did it, Miliband had hit on something. Buried in the costs of the transactions carried out by fund managers are hidden payments being made to brokers that are finding their way back to benefit the fund managers. These payments are not actually paid back to the fund manager, but they go to meet the expenses of the fund manager, when they should normally come out of the annual management charges it deducts.

Let me make it clear I have no evidence that the Neptune Mid Cap fund has been doing this – I cite that fund as an example of how high turnover of shares can increase costs.

But the FSA is concerned that most fund managers are. Last November it published a paper, Conflicts of interest between asset managers and their customers: identifying and mitigating the risks, spelling out its displeasure at the way fund managers have been spending clients’ money without telling them.

Here is how it works. When the fund manager buys some shares the broker doing the deal gives it two options. The shares can either be bought on a ‘clean’ or ‘execution-only’ basis, or with ‘research’ bundled into the deal.

Broker costs for buying clean might be typically 7.5 basis points (7.5 hundredths of a per cent), while buying with research might cost 15 basis points. That may not sound much, but over a 10-year investment the extra cost could knock 15 per cent off the value of your fund.

Crucially, despite paying for research costs, no research ever changes hands between the broker and the fund manager. Instead the extra 7.5 per cent from each trade executed is paid into a slush fund with the fund manager’s name on it. At the end of the year the broker then sends the money to whichever research the fund manager asks it to. The point is, research is what you are paying the fund manager the AMC to do. So why is it able to take more than the published AMC?

And worse still, of six big name fund managers I have asked how much of their clients’ money they spend in this way, only one, Standard Life Investments has been prepared to say, confirming around six basis points on its transactions goes towards research.

It’s a bit like buying a house and finding out that your solicitor has, with your money, paid for a special form of local authority search that costs £50 more than it should, but comes with a £50 voucher towards the solicitor’s electricity bill. And then won’t answer your phone calls when you ring up to ask about it.

Unbelievably, paying for research in this way is within the FSA’s rules. But the Investment Management Association, the trade body for fund managers, finally realises that it smells bad, and is canvassing members about changing the way they operate. With the Office of Fair Trading looking at practices across financial services at the moment, change may come sooner rather than later.




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