Why funds must come clean on hidden transaction costs

On 4 April 2016, Woodford Investment Management (WIM) announced they would be paying the research part of the transaction costs from their annual management fees, rather than passing these onto clients.

Whilst we applaud this decision, we have always believed that research is a fundamental tool of an active manager's job and as such should never be paid for separately by clients.

It remains a scandal that the wider UK fund management industry shows no willingness to behave ethically regarding transparency of these research costs, as well as overall transaction costs.

It is also exceptionally poor that the Financial Reporting Council has allowed the investment trade body, the Investment Association (IA), to set its own accounting standards, which resulted in it abandoning the requirement for funds to report their Portfolio Turnover Rate (PTR) after June 2012.

Portfolio turnover

Without this crucial statistic, it is impossible for investors to calculate the transaction cost.

In light of this lack of transparency, what was of great interest to us in the WIM announcement is its guide to wider total transaction costs. Woodford manages his fund with a comparatively low turnover of stocks, and tends to invest for a much longer period of time than most managers.

The announcement showed that the total transaction costs (execution costs + research costs + transaction taxes + spread) amounted to 0.09% in 2015, even though the portfolio turnover rate for the CF Woodford Equity Income fund was just 15.3%.

According to the IA, total funds under management for UK-domiciled funds investing in equities amounted to £524,266 million at the end of 2015. It estimates that tracker funds represented 12.4% of UK-domiciled funds, i.e. active funds represented 87.6%.

Utilising data from Fitz Partners, the average PTR for equity funds was recently found to be 64.7% a year, more than four times the WIM reported turnover.

SCM has used this data, together with the WIM statistics, to calculate that hidden transaction costs for actively managed UK-domiciled funds are currently running at around.0.38% a year - or £1.75 billion.

This will vary from fund to fund according to their individual PTR and the transaction costs of buying and selling the particular assets they specialise in.

For example, funds investing in less liquid securities, e.g. emerging market stocks or smaller company shares, are likely to result in far greater transaction related costs due to much higher spreads (the difference between the buying and selling price).

FCA should act urgently

The Financial Conduct Authority (FCA) should act urgently to mandate that all funds show, in a format that is "fair, clear and not misleading", full transaction costs and added to other ongoing charges.

This would make the "true" charge 45% more than the typical 0.85% a year headline charge (OCF) of many equity funds.

In May 2013 we launched a True and Fair Calculator, a free online calculator allowing investors to see exactly how much they are paying in fund management, including transaction costs via their PTR, platform and advice charges in one simple "Total Cost of Investing Number".

The calculator works out the cost of investments, giving an estimate of returns after costs and fees. It listed over 7,500 investment products across funds, investment trusts and ETFs, and received over 73,000 visits.

But due to the IA no longer requiring funds to publish their PTR, we were forced to amend the calculator in 2014, so users have to now enter their own data.

We have been informed on many occasions that fund managers have refused to give investors the necessary cost information to input details for their own funds. The site hosts a template and full assumptions document that any investor can download and send to their managers or adviser.

In any other industry, hiding such a cost would be illegal. It is shameful that neither the IA nor, more importantly, the FCA has ever properly addressed this widespread underhand practice.

The FCA and its predecessor, the Financial Services Authority (FSA), have had clear evidence of the effect of hidden transaction costs from as long ago as 2000, when its own commissioned research revealed that as much as an additional 50% of overall fund costs were hidden.

The EU regulator has been more decisive and, via the Markets in Financial Instruments Directive II (MiFID II) in 2018, will force the UK industry to be transparent as regards all charges - implicit and explicit - for the first time.

Until that time, pressure needs to be placed on fund managers to stop hiding fees and misleading their clients as to the impact of fees on their returns.

Gina Miller is founding partner at SCM Direct.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.