Fund charges: Unpicking Total Ongoing Cost

Rob Morgan explains the ongoing charges and costs that apply to open ended funds such as unit trusts and OEICs.

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  1. Rob Morgan

There has been a lot of publicity about fund charges this year, much of it surrounding newly disclosed costs under a piece of legislation known as MiFID II. This requires investment managers to state transaction costs that are charged to their funds, on top of the ongoing charges figure (OCF).

The OCF covers fund operating costs, including the fund manager's fees for running the portfolio (the annual management charge or AMC, but not any performance fees), along with other costs, such as administration, marketing and regulation. It is intended as a standardised method of comparing the costs of funds. However, it does not incorporate the costs involved in buying and selling the underlying investments in the portfolio – hence the new requirement for funds to publish the additional ‘transaction charges’ figure.

Now that transaction charges have bedded in Charles Stanley Direct displays two figures for a fund on its respective webpage, the annual management charge and ‘Total Ongoing Cost’, which combines the OCF, the transaction charges figure and any incidental charges such as performance fees – and replaces the previous figure that represented the OCF only.

Greater transparency – but still all is not clear

Trading within a fund is of course inevitable and necessary in order for managers to go about their job, and we welcome the further clarity of the full costs investors face when investing in a product and agree with the intention behind the disclosure.

Previously the cost of buying and selling securities was typically shown within a fund’s report and accounts making it difficult to uncover. Having it out in the open is a step forward in terms of transparency. Unfortunately, there are some problems with the methodology behind the transaction charges calculations meaning that investors should treat the figures with some caution.

The transaction charges figure is intended to capture the explicit and implicit costs involved in trading over a year. Explicit costs incurred include broker commissions and levies such as stamp duty, while implicit costs involve bid-offer spreads – the difference between the buying and selling prices of securities – as well as, somewhat controversially, ‘slippage’.

Slippage is the impact of any change in the price of a security between placing and executing a trade. It arises from market movement during any delay in transacting and can be positive or negative. For instance, a manager decides to sell a stock at 10am when the mid-market price is 96p (this is known as the ‘arrival price’). The transaction is executed at 11.30am, by which time the bid price has risen to 100p. The slippage cost on the sale is therefore -4p, a negative cost under the Mifid II rules.

Conversely, another manager buys a stock at 95p. However, by the time the order is executed the offer price has risen to 100p. The slippage cost on the purchase is therefore +5p.

Slippage costs are therefore something of a lottery based on short term price movements.  Furthermore, they are not really a cost at all; they just reflect whether the market moved in a favourable way or not in the immediate aftermath of an investment decision.

To complicate matters further the rules state calculations should be based on up to three years’ historic data but many managers have not recorded arrival prices over the past three years. Until the advent of the new rules they had no need to. Therefore they have not been able to accurately calculate the true slippage cost and have had to rely on estimations.

An overall lack of consistency when calculating transaction figures as well as the variability of slippage costs has resulted in a number of anomalies including negative, zero and very high figures. It is important to bear in mind when considering this element of a fund’s charges. However, it can give a loose guide to the additional costs involved in trading, and can also be useful in highlighting funds that have a particularly high or low level of trading activity.

Cost is important – but not always king

Fund costs will always be an important consideration when selecting funds. As you would expect, it’s something we look at closely when assessing candidates for our Foundation Fundlist. OCFs allow direct cost comparisons between similar funds, while the Total Ongoing Charges figure, albeit flawed due to the variability of transaction cost calculations outlined above, provide a fuller picture of the overall cost of investing. 

Yet probably the best like-for-like comparison of value for money is net performance – the return after all these costs have been taken into account. Published past performance information is almost always after charges, so while a complete breakdown of costs have not been disclosed explicitly by fund managers in the past, the effect of underlying charges, as well as the friction involved in trading, has. Performance versus a benchmark or peer group is, and always has been, there for all to see.

When assessing funds we find that low-cost passive investments that keep charges exceptionally low stand up to this scrutiny, as do differentiated and consistent active managers that are able to outpace their relevant benchmark over the longer term.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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