Newsletter 7 June 2012 : Investor costs and returns vs fund returns

In today’s newsletter we share two articles that focus on investor costs and returns. Why do investor and fund returns differ and how can investors achieve fund returns; and what costs need to be taken into account when examining returns.

What are you REALLY earning from your investments?

As an investor, your main concern may be about how the current volatile stock market is affecting your investments and the returns you receive. However, share prices aren’t all you must take into account – the charges you have to pay with investment funds also have an effect on your returns.

Have you considered what it is costing you to have your investments managed and how this is eating into your returns? What is your actual real return after inflation and after all costs? These are important questions to answer when establishing targets and managing expectations.

For example, assume an annual return of 10%, inflation (CPI) at 6% and the costs of managing your investment at 2%, then your net real return is 2%. This figure would be further reduced if you were drawing down any capital as in the case of a living annuity.

Andrew Ratcliffe of Private Client Holdings cautions that no one can expect to invest free of charge – that there will always be costs involved. It is important to know what those costs are otherwise it is impossible to make a properly informed choice.

“Investors must calculate their Total Expense Ratio (TER). This is the amount of your assets that have been sacrificed as payment for the services rendered in the management of your investments and is expressed as a percentage of the daily average value of the portfolio and calculated over a set period – usually a financial year.”

“The costs incurred in the management of a fund are deducted from the fund’s assets. These costs include management fees (including performance fees), fixed operating costs, (like custody and Trustee fees), audit fees, bank charges (other than those charged by an investor’s bank), Value Added Taxes and liquidity costs (like net negative interest charges), which is applicable in the unlikely event of a fund owing interest to a bank as a result of temporary liquidity pressure,” says Ratcliffe.

Performance fees

Performance fees do not always sound much, but they can result in total charges of more than double the advertised Annual Management Charges. For example, if a fund generates gains of 10% over its benchmark and has a 20% performance fee, the fund managers can claim an extra 2% fee. If it has a 1.5% annual management fee which, with additional running costs, becomes a basic TER of 1.65%, the addition of the performance fee will bring total deductions to 3.65%.

“Performance fees must be included in the TER calculation and must also be disclosed separately. This is to enable investors to distinguish between costs that may be charged to a portfolio regardless of its performance and a performance fee that may vary significantly from one year to the next. The cost of the performance fee, in rand terms, will be disclosed as a percentage of the average net asset value of the portfolio.”

Investor expenses NOT included in a TER

According to Ratcliffe, costs that are incurred directly by the investor and not the fund itself are not included, such as the costs of entry to an investment (eg initial fees and ongoing costs for financial advice if applicable), other costs incurred directly by the investor because of the investment (eg bank charges, exit costs and costs that are related to specific products, where these products invest in collective investment schemes, such as some life and LISP products).

“An example of this would be the cost of a Retirement Annuity which invests in collective investment schemes.”

Where will TERs be disclosed?

“TERs will be available through the newspapers and magazines that carry fund performances and charges, in monthly, quarterly and annual reports, in fund fact sheets, in Internet publications, with annual unit holder communications and on the ASISA website with the fund prices,” says Ratcliffe. “The latest TER must be disclosed to an investor prior to making an investment and this TER disclosure must be in addition to the other disclosures required under CISCA and the FAIS Act, eg notifications of risk and costs.”

“Investors must urge their asset managers to explore ways in which to reduce TERs. An example would be getting institutional pricing on asset managers in our unit trust portfolios, as opposed to retail prices as experienced on most LISP platforms,” concludes Ratcliffe.

South African investors missing missing out on returns

By Matthew de Wet, head of Investments, Nedgroup Investments

There can be large differences between the return that a fund generates (fund returns) and the return that investors in the fund actually receive (investor returns). These differences (the investor return gap) stem from the fact that fund returns are measured from the start of the investment period to the end, and assume no investor cashflows. In reality, investors contribute and withdraw from their investment over the investment period, or even switch between different funds – making their performance experience different from that of the fund in which they are invested.

By aggregating total cashflows in or out of a fund, we can approximate the average investor return and compare it to the fund return. The differences can be attributed to collective investor behaviour; the switching in and out of funds. We analysed the 15 largest South African equity unit trust funds over the past 10 years and compared fund returns to investor returns.

Some interesting observations emerged and include the following:

• Overall, investors fared on average 1.7% per annum worse than the fund in which they were invested. This 1.7% per annum loss of potential return is significant – if compounded over 10 years, it means that investors ‘lost’ nearly 20% of the compound return that a simple buy and hold strategy would have delivered. To put this in context, top quartile equity funds have only outperformed the average fund by 1.5% per annum over the past 10 years. This means that investor behaviour has been a more important determinant of investor returns than the skill of the fund manager they appointed.

• There exists a strong relationship between the investor return gap and the client-turnover rate a fund experiences. In other words, the more clients move in and out of a particular fund, the more likely they are to worsen their performance relative to that of the fund. This is because investors often switch from a fund that is going through a poor patch and switch into a fund that is having a good run, only for the relative performance to reverse thereafter.

• The chart below highlights the strength of this relationship. For example, the orange data point – which represents one of the 15 funds analysed – indicates that the client turnover rate in that particular fund was just over 25% per annum (annual net flows into the fund averaged 25% of the value of the fund over the 10-year measurement period) and the commensurate investor gap was minus 3% per annum.


Source: Nedgroup Investments and I-Net

In general, the higher the rate of client turnover, the more negative the investor return gap. The strength of the relationship is measured statistically by the fit – in this example it means that 49% of the investor return gap is explained by the degree of client turnover in the fund.

The more specialised the mandate, the greater the potential for a large investor return gap. This is due to the fact that the performance of specialised funds tends to fluctuate more than those with wider mandates, which causes discomfort among investors and increases the likelihood of switching during a ‘negative’ fluctuation. As an example of this, we analysed the small-cap unit trust universe. Over the past 10years the investor return gap for one particular fund was minus 12.5% per annum. This fund delivered a total return in the region of 140% over the 10 years, but the average investor suffered a loss. A good fund return with a poor investor return should be seen as such – a poor outcome for investors.

It appears that South African investors may actually behave better than their global counterparts. The often quoted Dalbar survey postures that over a 20-year period, US balanced fund investors received up to an 8% per annum lower return on average than the funds that they invested in.

It is clear from the points highlighted above that investors are not harnessing the full magnitude of the returns available to them from the funds that they invest in. The responsibility to improve the investor outcome rests primarily with us, the investment provider. We make it our business to market our funds appropriately and continually emphasise the importance of investing for the long term. Highlighting short term performance numbers and promoting funds that are currently ‘hot’ (as well as not talking about funds that are currently ‘not’), effectively encourages our investors to actively switch between funds, which will in all likelihood detract from their performance experience.

The opinion and comment in this newsletter is opinion and comment only and does not in any way constitute financial advice. For all investment and financial decisions please consult a professional financial planner.



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