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Costs and Charges

Think of the true cost of investing as a North Atlantic iceberg. There is the visible mound afloat (commissions, administrative fees, annual management charges and taxes), but a far more substantial body of potentially Titanic-sinking frozen water hidden from view below the surface (the bid-ask spread, market impact, delay costs and missed opportunity costs).

That which is in view is nonetheless shrouded in jargon. For a fund, an Annual Management Charge (AMC) is the amount paid to the fund manager for getting out of bed in the morning. The Ongoing Charges Figure (OCF) is this AMC plus the fund’s other operating costs, such as charges incurred in buying and selling investments. Confusingly, the OCF was previously referred to as the Total Expense Ratio (TER). There is little different between the two, though the former also includes performance fees and has the clarifying enhancement of avoiding the word “total”, which neither are. For example, both exclude stamp duty (currently 0.5% for UK equities), and the hidden implicit costs of investing.

A performance fee is an additional charge levied on the fund’s investment returns, and has been most prominent in hedge fund circles. The Eclectica Absolute Macro fund, for example, charges 20% on any positive performance in addition to an AMC of 1%. Thus if the fund makes 6%, an investor gets 4%. Usually these come with a high watermark provision, meaning performance fees are not levied twice in a fund that oscillates between outperformance and underperformance. The problem with performance fee structures is that they can create a mismatch of interests between investor and fund manager. Notice that the fund manager is incentivised to take huge risks in the hope of a big performance fee bonus since, unlike the investor, he is not risking any capital should the fund underperform. Heads I win, tails you lose.

Then comes the less obvious costs of investing: the iceberg below the surface. The bid-ask spread is the difference between the market price to sell and buy a share; for smaller companies with few daily trades, the difference can be over 10%, which is an immediate painful paper loss. Large orders that are staggered can also move the market as they are invested, while delay costs (or slippage) arise when an investor is unable to trade due to lack of liquidity. Failing to execute a trade in a timely manner risks information being leaked into the market and the price galloping skywards. These implicit costs are invisible though nonetheless significant.

In a low growth, low inflation world, there is a drive to lower the cost of investing. Fees can mount quickly, particularly in those matryoshka doll arrangements where between an investor and investee are seated a financial adviser, a platform, a wrapper provider, a discretionary investment manager, a fund of funds manager, and a fund manager – all six of whom are taking a bite of the cake as it is passed around. It is for an investor (and their trusted adviser) to determine if each is doing enough to justify his or her invitation to tea.

The existence of icebergs in the Atlantic should not keep you shore-bound; it should though prompt careful planning. Neither is the cheapest route necessarily the best course. What matters is your total real return after all costs and taxes. While excessive fees are detrimental to long-term investment returns, even more so is poor investment decision making.

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