Spotting the charges cheats

12th June 2012

The 1.5 per cent annual management charge levied on most unit funds  – translated often in a 2.3 or thereabouts per cent on to a total expense ratio (TER) calculation, or, for the more sophisticated, the "two plus twenty" model in hedge funds where managers take 2 per cent a year and 20 per cent of gains, is up for challenge.

Management firms need to justify these fees. For even a small reduction will boost returns, especially for long term investors. The maths are not difficult – a 0.5 per cent reduction over ten years equates to more than 5 per cent extra on the final total.

Better returns from non-market assets

A new publication from consultants Towers Watson suggests that private investors are well as institutional funds are now looking at some of the more specialised areas of the financial scene to push up returns.  Many of these are not listed leading to the need for investors to take extra care in due diligence.

There is a hidden advantage in looking at some of these often neglected areas such as farmland, timber or infrastructure – the fund fees have not become ossified as those in more conventional assets. Investors are better able to find bargains as far as charges go.

Others have opted for low cost index tracking funds – they typically return one percentage point more a year thanks to smaller fees which equates to adding around 11 per cent over a decade. These funds have fans and foes but over long periods tend to beat around two thirds of their peer group – sometimes more once the weakest funds which are closed or amalgamated are added back into the mix. There is also the exchange traded fund option for more sophisticated investors. 

Sorting your alpha from your beta

But before ditching funds for the plain vanilla tracker or the exotica of alternatives, investors need to know whether their present managers and their existing funds are earning their keep.

It's all a question of alpha and beta. As well as being the first two letters of the Greek alphabet, these are essential investment management concepts.

Beta is the relationship of a fund to its benchmark. A fund based on the Standard & Poors 500 would have a beta of one if it replicated the volatility of the index. A number lower than one would imply less volatility – higher than unity would be riskier.

Alpha is the return a fund manager adds in addition to the return from beta. Achieving the same as the index but with a lower volatility – say 0.8 – would imply an alpha success. Achieving the index with a higher than one beta – 1.5 perhaps – would be seen as negative alpha, a fund manager who destroys value by taking more risks than the return would justify.

The first manager could claim skills to justify fees; the second should be sacked.

Watch out for leveraged beta

But sorting out the good from the bad is not quite as easy as alpha and beta. Some managers claim alpha when all they have done is to identify a trend, aim for 1.0 beta while pushing up the returns via leverage.

Borrowing at today's low rates makes sense. A basic example would be of a £100m fund divided into 100m units which borrows £50m at 2 per cent. The £150m fund then achieves annual growth of 4 per cent – £6m – with a beta of 1.0. The interest is £1m so the return is £5m or 5p per unit. Without the gearing, the return would be £4m or 4p per unit. The 25 per cent uplift is not the result of fund manager skill, merely gained from low interest rates. If interest levels went back to 5 per cent, this would be a losing strategy.  Some asset managers employ leverage more than others.

In this instance, the manager claiming better than beta returns and a higher performance fee should hang their head in shame. This is not alpha.

Basic questions to ask:

What is the fund's benchmark?

What is the beta?

How does that compare with the actual returns?

How much is borrowed if anything?

What percentage of the return is down to beta, and how much to alpha?

How does the fund manager explain the fees when alpha turns negative?

Or go for a simple tracker

The tracker fund – with annual charges around a third of active funds at around 0.4 per cent per year – should have a beta of 1.0. Paying more than that is over-rewarding. There are trackers covering most mature – and some emerging – markets. There are also passive funds investing in sectors such as pharmaceuticals or finance.

New generation of low cost funds

One alternative is to aim for a low cost fund which tries to achieve alpha with charges that are better recognised in the world of passive investments. One range comes from Schroders but the concept will take time to register.


More on Mindful Money:

How to spot a star fund manager

RDR: The state of UK financial advice

Will RDR create an 'advice gap'?

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