Tim Harford, in his book The Under Cover Economist, makes the point that it is very difficult to out-perform the market over the long term, and concludes his argument by writing: “we should gently invest in a wide variety of shares, with no expectation of making a killing – we should diversify, keep charges low and avoid trying to be too clever”.
Good advice, although, in one respect at least, difficult to follow. We can all agree that investment costs should be low (although they should be low and optimal, as opposed to low for the sake of it) but how can we be certain they are when they are so opaque?
This dilemma is exercising the FCA, amongst others. They issued two consultations – endorsed, albeit tersely, in Parliament by the Pensions Minister – addressing the issue late last year. So it seems likely there will be change. What’s less clear is the timing and form of that change. In the meantime, then, what can trustees do?
They can ask questions.
This blog, the first in a mini-series, begins to set out a map of where costs can occur in the investment process. Trustees should use the map to challenge their investment managers.
The shape of the costs map
It’s easy to imagine that the shape of investment costs is pretty straight forward: we all know about annual management charges (AMCs) and transaction costs, after all. Would that it were so.
The key landmarks of the costs map are:
- Costs have both quantum (the absolute amount of cost) and duration (the timing of costs being deducted)
- Costs can be “above the line” as well as below it. The line is where the unit price is calculated. It follows from this that,
- Costs can be explicit (i.e. deducted after the unit price has been calculated and reflected in the “net return”) or implicit (i.e. deducted before the unit price is calculated and reflected in the unit price). Whether explicit or implicit, they are costs and act as a drag on the return
- Costs can be specifically contractual (for example, “we will deduct an annual management charge of x%”) and non-specifically contractual (“we will deduct the costs of trading”)
- In defined contribution (DC) schemes some of the costs are restricted by law.
Using these landmarks the map looks like this:
One final point, although not one really relating to the map itself: not all costs go into the pocket of the investment manager – some of them are costs they incur in looking after money. Let’s call these second-hand costs. While the important thing in relation to “first-hand costs” is that they are fair, the important thing in relation to second hand costs is that the manager is controlling them and keeping them optimal.
In the remainder of this mini-series of blogs I’ll populate the areas of the map, covering:
- Above the line costs
- Below the line costs
- DC specific cost issues
- The weaknesses in the transaction costs proposals.