The cost of managed funds in Ireland
MANAGED FUNDS IN IRELAND
INTRODUCTION
If "active" and "passive" management styles are defined in sensible ways, it must be the case that :
(1) Before costs, the return on the average actively managed euro will equal the return on the average passively managed euro and
(2) After costs, the return on the average actively managed euro will be less than the return on the average passively managed euro.
These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.
William F. Sharpe, Nobel Laureate in Economics, 1990, The Arithmetic of Active Management, The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991.
The implications of the “arithmetic of active management” are that the difference in performance between the average passive portfolio and that of the average active fund manager just reflects the differences in fees and expenses. Active management is ALWAYS going to lose on average just on the basis of fees and expenses.
However, detailed information on the fees and expenses paid by retail investors in Ireland today is relatively difficult to obtain. For example, Insurance Companies are not required to provide a detailed fund prospectus for their Unit- Linked Funds.
Investment funds typically quote an annual management charge of 1% to 2%pa and many investors believe that this is all that they pay in charges. However, additional hidden costs are present in all investment funds and our research has attempted to estimate the true costs of investing using International studies.
Some of the additional charges that are not included in the annual fund management charge can be estimated from the average of those funds which are required to disclose their fees and are typically as follows:
· Custodian Fees 0.011% - 0.608%pa
· Expenses 0.15%pa
· Administration up to 0.25%pa
Taken together with the annual management charge, these additional costs represent what is known as the Total Expense Ratio (TERs). Recently Morgan Stanley estimated that the average TER across Europe was 1.91%pa for an average actively managed equity fund.
According to research by Lipper Fitzrovia in the UK in January 2007 the average fee for multi-manager funds investing into equity funds is 2.2%pa and can be as high as 3%pa. Breaking this down further, the average inclusive TER for a fund of funds investing principally into externally managed equity funds was found to be 2.44%pa.
Portfolio Turnover
An additional cost of investment which is often overlooked by investors and their advisers is the impact of trading within a portfolio. Perhaps the easiest way to think of this is that every time a fund manager buys an Irish Stock, a Stamp Duty of 1% applies to the purchase. Therefore, the more “active” the fund manager is at trading stocks, the more the fund has to pay in expenses such as stamp duty and brokerage commissions.
We have reviewed several studies into these additional hidden costs associated with portfolio turnover. Trading stocks within any fund (even an index tracker or ETF) creates additional costs such as stamp duty, broker commissions etc. These additional costs are also born directly by the investors in the fund and are not included in the TER.
A study in the UK by the Financial Services Authority estimated that the additional costs for a typical fund turning over 80% of its holdings in a year could add an additional 1.44%pa in costs.
An 80% turnover might seem like a really high number and one might think unrealistic. But think about it this way, how else is an active fund manager going to justify their additional costs unless they are being "active".
We tested this premise by looking at the stocks held in the Eagle Star 5 Star 5 Europe between 1/1/2008 and 1/1/2009. Of the 25 stocks in the fund at the start of 2008, only 5 were still in the fund at the start of 2009. Therefore 20 stocks were sold during the year or 80% of the fund.
Another Lipper Fitzrovia study into UK investment funds in 2007 concluded that the average turnover for a range of popular investment funds averaged 74.57%pa
Conclusion
Fund managers in Ireland do not benefit from the economies of scale seen in the USA or even the UK. We estimate that the possible cost of investment for the average Irish retail investor is of the following order of magnitude:
Quoted Fund Management Charge: 1.00%pa
Additional administration and Custody charges: 0.91%pa
Hidden trading costs: 1.44%pa
Total: 3.35%pa
All investors in aggregate form the market. Therefore, it must be the case that the average investor earns the market rate of return less fees and expenses. Managing costs (management fees, operating costs, trading costs, taxes, etc.) allows investors to capture more of the capital market return that is there for the taking.
At GoldCore Ltd by recommending passive index funds, we keep costs down which puts the odds of success in the investors favour.