Portfolio charge perspective

Labour’s intervention into the fee debate has put portfolio turnover rates and associated costs in the spotlight. Paul Farrow investigates an industry finding the glare uncomfortable

Pension providers insist that they are willing to be open and transparent on charges and fees yet when it comes to revealing portfolio turnover rates (PTRs) and associated costs they clam up.

If you believe the anti-fee brigade this refusal to disclose these additional costs is tantamount to fraud. Alan Miller, co-founder SCM Private says:“Unless providers are up front about portfolio turnover costs it is nothing less than institutionalised fraud as investors have no idea whatsoever of the costs borne by their fund manager in terms of trading.”

Miller adds: “These costs need to be incorporated in the headline number rather than disclosed separately to avoid the normal game of investment costs ‘hide and seek’. As the recent Kay Report concluded, disclosure of such costs is useless unless it is comprehensive –therefore, all dealing costs need to be included.”

One of the reasons why providers are reluctant to disclose PTRs is that they vary enormously between different funds. Pension funds invest in equities, bonds and other securities, which may be traded by the fund manager with the aim of maximising returns on the fund. Such trading involves transaction costs (including stamp duty on UK equities). The extent of trading varies both between fund managers and sectors. The cost of trading also varies between sectors–as the NAPF points out it is higher for UK equities, for example, because of the stamp duty.

What is clear is that the higher the PTR, the higher the transaction costs are likely to be, which may impact on performance.

Graham Wood, senior consultant at State Street, says:“PTRs will be a drag on performance. There is no question of that.”

However, a high PTR may result from a deliberate strategy whereby fund managers take market opportunities to enhance performance. In certain instances, the PTR may be unusually high or low, or even negative. Generally though, equity funds have lower PTRs than bond funds as the frequent rerating of bonds may force managers to trade, say experts.

Miller’s firm SCM Private has analysed 5,000 individual pension funds with £485bn invested and found the average reported fund turnover of these funds was 119 per cent.  Given that the reported turnover numbers double count purchases and sales, this indicated an average turnover of 60 per cent, which based on SCM’s estimate that the real cost of buying and selling a typical bond or equity is 0.73 per cent, means there is 0.43 per cent of costs being hidden. The average reported management fee of these pension funds was 1.3 per cent per year, so SCM claims that at least a third of the fees are hidden from investors.

Research also suggests that the drag on performance is not to be ignored. According to research from Frontier Investment Management an initial investment of £100,000 averaging growth of 10 per cent a year for 30 years will experience considerable fee drag on a TER of 1.6 per cent a year. While the gross return for such a fund after three decades is £1.7m, the net return would be just £1.1m, a reduction of 35 per cent of the value of the investment. Frontier then calculated that, on the same £100,000 30-year investment, an average PTR cost of 1.8 per cent a year net reduced returns to £700,000, resulting in 53 per cent of the gross return being eroded through fees and transactions.

This, however, is just an example and many pension providers’ scoff at any suggestion that they are making money out of hidden fees.

Most providers that Corporate Adviser asked to give examples of PTRs and associated costs stated that it wasn’t fair or practical to reveal such information. These included providers such as Legal & General, Aviva, Scottish Life, while other providers such as JPMorgan, Fidelity, Newton were unable to help. Aegon was forthcoming with figures for its largest default fund, however –confirming that the charge on its Balanced Passive fund, has a 1 per cent AMC and TER, with total extras are 1.22 basis points.

Some of those that offered some explanation insisted that “they were fully compliant” with what they are expected to disclose and most were quick to point out how cheap their TERs were. Legal & General, for example, was quick to state that its two most popular default funds, UK Equity Index and Global Equity Fixed Weights charge TERs of just 0.1per cent.

Alasdair Buchanan at Scottish Life says that there must be more to the debate than shrill talk about “rip off pensions” and “hidden charges”.

He adds: “Some of the charges–trading costs –are not levied by the provider. This is not to say they shouldn’t be disclosed–but there is no consistent format for obtaining and disclosing this information. We are obviously aware of the current debate around ‘hidden charges’. Without going into the rights and wrongs of this debate, we support the need to demonstrate total transparency of costs. This has to be on an agreed basis across the whole industry.”

A spokesman for Friends Life says:“Providers are not hiding charges. We are fully compliant with the requirements set out by the FSA and disclose all our charges very clearly to customers in advance. This disclosure includes many of the additional costs that are incurred on the funds that products invest in.

“Any discussion of costs and charges should not focus solely on reducing dealing costs as there is a risk that it is seen as better to be investing in a fund that has a lower turnover of stocks than a fund where the fund manager is actively managing the fund.”

Aviva, one of the UK biggest insurers, didn’t want going to play ball either. Its spokeswoman said: “We would be reluctant to give details [on PTR’s and costs] as it wouldn’t be helpful to consumers. They need to understand how it is calculated and it wouldn’t be comparing apples with apples. The industry needs to work out how this is done.”

Providers also insinuate that PTR costs are minimal and their views are backed by Brian Henderson, a consultant at Mercers. He said that PTRs is one of many considerations he uses to assess DC funds, but says that a high PTR won’t rule out selection because it could be that the fund delivers on performance. “But they [PTR costs] are small relative to the fund management charge,” he says.

Indeed, analysis by State Research last year suggests that many fund managers are not needlessly trading to boost fees. It examined some big institutional funds over three years and found that up to a third of stocks are actively traded, but around a fifth are held. Of those that were traded it was concentrated on big stocks suggesting that managers weren’t needlessly flipping share to boost fees.

The Investment Management Association, perhaps not surprisingly, also believes PTRs are being overstated and pours water on the argument that many PTRs exceed 100 per cent.

It says:“This implies that funds turns over completely every two years. A different picture emerges if one instead looks at the number of continuously held companies.”

The IMA looked at one of the UK’s top 10 selling funds and found that of the companies held in 2011, some 75 per cent were in the portfolio a year earlier, accounting for an average of 82 per cent of the holdings by market value.

“This drops to 56 per cent of companies held continuously for two years, but accounts for 68 per cent by value,” it added.

That providers are being compliant on what they are supposed to disclose as deemed by the FSA, has never been in question. That’s why they are keen to shout about TERs. But the issue some advisers have with PTR’s is whether they should be revealed on transparency grounds, to enable intermediaries to better assess whether funds are delivering value for the level of active management engaged in. No-one is suggesting members of the public need to be confused by PTR data, but some advisers would like to know what is going on inside big pension funds.

Standard Life seems to be more open than most providers questioned –and it suggests that members are kept in the dark to a degree on the overall costs of a fund.

The Edinburgh-based insurer’s head of workplace strategy Jamie Jenkins says that even though charges have come down in recent years it is still not enough.

He says: “Over recent years, investment funds have become more sophisticated in order to meet the varied needs of consumers, such as reduced volatility. As a consequence, the structure of charges has also become more varied. While pension charges have reduced considerably over recent years, and continue to do so as providers improve the efficiency of their operations and competition in the market increases, we realise that greater transparency of pensions charges is an issue that our industry must address. Separate to charges, the necessary costs associated with running investment funds could also be better explained.”

The National Employment Savings Trust (Nest) agrees and although it has yet calculated its PTR (because it is not directly investing but using a fund of fund structure) it has started a project with its fund accountant, to work with all of its fund managers to try and establish an aggregate PTR for the Nest funds.

A spokesman for Nest says: “This is a complex project, relying on many different fund managers to supply data, so it does have costs associated with it, and we need to at all times justify these additional costs. In this situation we believe that as transparency is one of our core values we should provide this data, but it may be that it is not available in the short-term.”

Much is being made of the level of pension charges over recent months and how it cuts into the final value of your pot. The industry is moving to lower costs but there has to be some costs –after all you would be wondering what an earth your fund manager was doing if he was running an active fund without trading. But we are in the age of transparency and pressure will continue to be put on fund providers to be open on all costs–even if they don’t believe it is necessary.

Tom McPhail at Hargreaves Lansdown, says:“A total cost of investing disclosure would be useful for employers but it should be incorporated into a broader disclosure around what services are being provided to the employer and the employee and how these are being paid for –this is something the NAPF is exploring.”
Meanwhile, the ABI hints that it believes that PTR disclosure is inevitability. A spokesman said: “We believe it is a question of ‘how’ rather than ‘whether‘ these costs should be disclosed, and are keen to consider ways to improve the FSA disclosure regime that will help employees better understand their pensions.

“The Investment Management Association is consulting on enhanced disclosure of fund charges and costs and we are fully engaged in this. We are also discussing with our members how best this can be achieved.”

Working example

Standard Life was only one of a handful of pension providers to actually give Corporate Adviser actual PTR numbers based on a holding in an actively managed, broadly diversified, well established UK equity fund, which could typically be used as the major component of a default lifestyle strategy in a pension scheme.
The annual management charge would be around 1 per cent, although this is then reduced by the scheme discount. This would reduce it by 0.48 per cent to 0.52 per cent, for a typical scheme implemented today. This charge includes management of the fund itself, and the provision of all services to the employer and employees from the provider.
In addition, there would be minor additional expenses, typically around 0.01-0.02 per cent, which include custody, legal and audit fees, as relevant. Should a mutual fund be chosen rather than a unit-linked life vehicle these additional expenses might be slightly higher due to the inclusion of registrar charges – these will be clearly outlined in the relevant mutual fund prospectus document.
Over and above this are any transactional costs due to trading within the fund; these are the expenses incurred by the fund manager on behalf of the fund, and include brokerage fees and stamp duty. In other words, the costs of trading the underlying stocks and shares.

It is important that these “active management” expenses are judged against the performance objectives of the fund such as either out performance relative to an appropriate index or performance after applying some SRI, ethical or other governance restrictions. 
Transactional costs are estimated by first looking at the typical ‘spread’, or range, between the selling and buying price of underlying shares.  The spread in a UK Equity Fund would typically be approximately be 0.3 per cent from the bid (selling) price to mid-price, and 0.8 per cent from the mid to offer (buying) price (including the obligatory 0.5per cent stamp duty). This gives a total spread of 1.1 per cent. If you then assume that turnover of stocks within the fund in a year is 20 per cent, this generates an additional cost of 0.22 per cent (1.1per cent x 0.2 – 0.10 per cent of which is Stamp Duty).

Total cost to investor in this example is 0.76 per cent.

This overall cost should be balanced against the long-term objectives and success of the fund in question. To put this in context over the last 12 months (17th August 2011 to 17th August 2012), a typical UK Equity Fund returned 12-14 per cent.
Jenkins says: “The challenge is to find a way of expressing these expenses to customers in a way that is easily understood, and meaningful and in a manner and context that allows them to judge for themselves whether they are receiving value for money. We are actively working towards this.”