Active Funds; why does nobody mention trading charges?

Ben Raven - Head of Business Development

This week the front page of FTfm read “99% of active US equity funds underperform”. The article spanned two pages, five columns and included quotes from half a dozen industry professionals. To summarise in seven words; active funds are over-priced and under perform.

Within the article an MEP comments that investment houses are “over charging their clients and failing to put investors first”. An industry CEO claimed fund managers are “essentially sitting on large amounts of assets and charging the wrong fees”. He also stated they were “unable or unwilling to take the risks to try and out-perform their indices”.

What struck me about the article was not the findings of S&P’s research, nor the views of those lambasting the active sector. It was how a front-page article in a national paper, referencing politicians, the regulator, consumer protection groups and several asset managers could miss the point so badly. The article was so focused on active funds under-performing their benchmark that it failed to address the relevant question:

“why is this happening?”

There is a reason $24tn is invested in active funds globally. Active managers are not unintelligent. Nor do they go out of their way to do a bad job for investors. Castigating them for underperforming over a specific time frame does not help the underlying client, nor their IFA, understand why so many struggle to outperform a benchmark. Almost lost in seventeen paragraphs of repetition, were six words which give an insight into the real issue; over the decade in question “high costs were hurting investment returns”.

In order to understand this underperformance, one must examine the cost of running an active fund. This is not just the Ongoing Charges Figure (OCF) that appears on a fund factsheet. An OCF represents the tip of the proverbial ice-berg. An active fund manager, in their quest to outperform a benchmark, must place a number of successful trades over time. Identifying these trades and recognising the right time to place them, are only two parts of the puzzle. Once an active manager decides to place a trade they must incur a cost for doing so. This cost may come in the form of a bid/offer spread, a brokerage fee or paying duties if purchasing an equity. Whatever the guise, an active manager must pay a cost when entering into every trade. To make matters worse, they must incur a further cost when exiting every trade. Therefore, if we make the (big) assumption that the average trade is successful, it must be successful enough to absorb two rounds of trading costs before it breaks-even for the fund. This is the best case scenario and by no means guarantees a significant contribution to fund performance.

How much can trading costs add up to?

One study, which aims to shine light on the “invisible costs” of active fund management, looks at 1,758 equity funds around the globe. The study concludes that trading costs have a negative impact on performance and are, on average, larger than the expense ratios quoted by the active fund managers. Across the sample the average trading costs were 1.44% per annum. For small-cap funds it was as high as 3.17% per annum. To be clear, these trading costs come in addition to the OCF published by active fund managers.

Let us consider this for a moment. We operate in an industry where an active fund manager is only obliged to provide an OCF number which takes certain costs into account. These include anything classified as fixed, such as a fund manager’s AMC, audit fees, legal fees, custodian fees etc, as well as any cost borne by the fund with certainty over the next twelve months. On average let’s assume this results in an OCF of 1.00%.

Now let us consider the average trading costs incurred by that fund over a twelve-month period (trading costs are classified as variable, and as such do not need to be included in an OCF). Suddenly, the average active manager must clear an approximate 2.5% cost hurdle every single year before any client gains a single penny.

Therefore, an active manager must make 2.5% each year before they break-even. Combine this with the fact that not all trades are successful and you begin to appreciate the headwinds confronting an active manager.

The aforementioned “high costs hurting investment returns” comment comes from the same MEP that claimed fund managers were “failing to put investors first”. An active fund manager will argue that they spend all day, every day, trying to do exactly that. By incurring significant trading costs, active managers demonstrate they are not “unwilling to take the risks to try and out-perform their indices”. However, this willingness appears to go hand in hand with exactly why they appear “unable” to do so.

Trading costs can often be the single largest expense incurred by clients, yet seldom get mentioned by asset managers or elsewhere in the industry. As an IFA, are you aware of the underlying trading costs within the portfolios you recommend to clients? Are you sure the “all in figure” you quote your clients (including your adviser charge and platform fee) is accurate? A client’s true annual cost hurdle could be drastically different…..


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