Hyperactive funds: do they add value, or just costs?

We ask if frequent trading fund managers really add much value to their funds, or just create more opportunities to make mistakes.

At long last the lid has been lifted on the true amount investors hand over to fund managers every year, thanks to new regulatory rules that have forced managers to disclose transaction costs incurred through trading activity.

As Mike Barrett, consulting director of platform consultancy the lang cat, points out, such costs are nothing new – indeed investors have always paid them – but up until the start of 2018, when the rules took effect, investors were kept in the dark as to their value.

What happens is that both trading costs and the ongoing charge figure (OCF) are subtracted from fund performance. But while trading costs are now visible if investors know where to look (more on that later), they have never been part of the OCF – the price tag shown prominently on fund marketing literature such as the fund factsheet.

Transaction fees include explicit costs the manager incurs for administering the fund (broker commission, taxes, custodial charges), as well as any implicit costs associated with trading activity. According to analysis by the lang cat at the start of 2018 that looked at the top 20 most popular investment funds, transaction fees typically add a third to the OCF (see accompanying infographic for how total fund charges add up).

Therefore, as Barrett points out, fund firms were not exactly overjoyed at having to disclose these fees. He adds: "They have come kicking and screaming to the party rather than doing it openly - it has taken European Union regulation to get these charges out in the open so investors know what it costs to invest with them." An exception was Vanguard, as it had been upfront in regard to disclosing such costs prior to the rules coming into force.

Unfortunately, though, despite the regulatory requirement to display the charges, fund firms have not been quick off the mark to make it easy for investors to find the transaction costs. For example they do not typically appear on the only piece of literature most people are likely to read before buying a fund – the fund factsheet.

Less than forthcoming

Some firms do stand out, such as JPMorgan Asset Management, which produced a handy jargon-lite guide explaining how transaction costs are calculated. But collectively, the industry has been less forthcoming.

Instead, the onus has fallen on distributors, the platforms that offer a home for private investors to buy funds and other investments, to spell out the charges through a cost disclosure document highlighting all the costs incurred when buying a fund (including transaction costs), expressed both in percentage form and as a cash amount. All platforms should make the cost disclosure document available to view before any fund purchase.

Rebecca O'Keeffe, head of investments at interactive investor, adds:

"The cost disclosure document gives a much a better sense of how you are paying to have your money managed for you, as the OCF does not represent the full costs of the fund."

Upon finding out a fund has high trading costs (where 'high' constitutes more than a third of the OCF as a rough average, based on the lang cat's analysis), investors should not be immediately concerned.

After all, strong performance may justify it. Thus, if a fund manager deems it necessary to chop and change holdings frequently in order to successfully outperform the market, and delivers the goods on that front, then a premium in terms of the overall charge is justifiable. But if performance fails to shine, those funds with high turnover or ‘churn' will pass on higher costs to investors, and will warrant closer attention.

The other side of the coin, for those investors who back fund managers that seldom trade and therefore pass on less in the form of trading costs, also comes down to performance.

Those fund managers that patiently buy and hold for the long term and are successful at doing so look like geniuses. But if performance takes a turn for the worse and turnover remains low, the low trading fees incurred are no consolation prize.

As O'Keeffe notes:

"In some cases it is worth going with a fund manager with high trading costs. Personally, as an investor, providing that I will get significantly more in terms of the overall total return, then I don't mind."

Negative costs

Bizarrely, transaction costs can be negative in scenarios when fund managers get lucky when they trade – for instance if they place an order to sell a share, and by the time it has been executed the share price has risen in value – thereby negating the transaction fee. If this happens on enough trades, investors incur no costs.

Arguably the biggest downside to the high-turnover trading approach is that there are more opportunities for the fund manager to make mistakes. O'Keeffe agrees, adding: "Churning the portfolio too much can be a sign the fund manager is chasing performance, which is worth bearing in mind."

This increases risk, acknowledges Adrian Lowcock, head of personal investing at Willis Owen.

But he points out: "What is more important is the necessity of trading to execute the investment strategy, as some funds need to be more 'active'; for instance a value fund that hunts for cheap shares will trade more than, say, a fund that favours quality growth businesses."

Therefore, it all ultimately boils down to two things: the strategy of the fund and the fund manager's style. In terms of strategy, passively run tracker funds should have low trading costs and certainly lower than the majority of active funds, as they typically rebalance their holdings every quarter -so only four times a year.

'Hyperactive' funds will include those with the 'absolute return' moniker, particularly those where the fund manager also bets against certain shares – known as short selling. The lang cat's research last year found that in the case of Janus Henderson UK Absolute Return, the transaction cost of 0.79% was almost three quarters of the stated OCF of 1.06%. Of the 20 funds it looked at, this fund had the highest trading costs.

Whether trading costs are high or low reflects a fund manager's approach to investing. And on that front consistency is key . In the event of a fund manager departing, the replacement is also likely to put their own stamp on the fund, which will probably push up trading fees. Again, this is no bad thing providing that performance is up to scratch.

The types of fund costs you probably didn't know about

Ongoing charge figure - 0.85%*

• Annual management charge paid to fund manager
• Operating and administration costs
• In a fund of funds, the cost of the underlying funds

 *(typical cost of a fund that buys shares in a developed market)

Transaction cost (where applicable)

• Broker commission
• Research commission
• Stamp duty
• Exchange rate levies
• Administration fee from lending stock (short selling)
• Transaction 'arrival cost'*

 *Difference between the price at which an asset is valued immediately before an order – the arrival price and the price at which it is actually traded (the execution price). Can be negative.

Other potential charges

• Performance fee
• Initial charge if fund is ‘soft closed'
• Exit fee (very rarely applied in the case of funds)

Source: JPMorgan

ICG Enterprise Trust: cost maze

Additional costs on some specialist investment trusts can prove almost impenetrable for retail investors, as one reader's experience with the private equity trust ICG Enterprise demonstrates.

She contacted Money Observer for help in understanding the discrepancy between the ongoing charge of 1.36% listed on the trust's factsheet at the end of April 2019, under key facts, and the total costs and charges disclosed on her annual statement. These amounted to a massive 5.83%, broken down into ongoing costs of 3.18% and incidental costs of 2.52%. In the Key Information Document, meanwhile, total costs were shown as 6.09%, reflecting different time periods.

We contacted ICG for an explanation, and were provided with a threepage document explaining the various complexities and emphasising how the charges are all in line with regulations.

The AIC comments:

"We agree that the different cost disclosures can be confusing, which has not been helped by recent decisions taken by regulatory authorities."

The AIC points out that private equity trusts do tend to be relatively expensive compared with listed equity peers. "For example, they have greater costs in terms of negotiating deals, and play a much closer role in managing the companies they invest in,” says a spokesperson. That's understandable, but headline OCFs are then largely meaningless as a guide to costs.

So ICG Enterprise is following the letter of current law in its presentation of the management costs. However, total costs are a very far cry from the headline figure quoted, and for retail investors these complex additional charges are extremely difficult to understand. Surely the industry can find a way to balance clarity and complexity?