What your local council can teach you about investing

There's a fascinating piece on the front page of this morning's Financial Times.

It's all about the huge difference in the fees paid to fund managers by various local councils to run their pension funds.

The gap is staggering. Some councils are paying four times as much as others in investment management charges. According to the FT, that would represent £5.5m a year for an average-sized fund.

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That's the sort of money that could make a big difference to taxpayers. It also provides some useful lessons to the rest of us about how we pay for investing

The local authority pension gap

UK councils manage nearly £190bn in pension funds for around 4.2 million members, according to the FT. But data from London consultancy Investor Data Services shows that there are huge differences in the fees paid by different councils.

The FT highlights the gap between Devon and Staffordshire councils as an example. Both funds are about the same size around £2.6bn. They are invested in similar assets: the top three shareholdings are the same, for example. In both cases, over the past decade, the funds have returned around 6% a year before costs. Yet over that period, Staffordshire paid nearly £40m more in management and admin fees.

Because the data is not particularly transparent, it's hard to draw explicit conclusions. But it doesn't take a genius to realise that if you are paying £40m more in fees for the same performance, then that's going to hurt the end return you get.

To be fair, some councils seem to be making a decent effort on the behalf of their taxpayers. One unnamed council noted in the FT managed to get its fees down to just 0.05% in one year. It had given all its assets to one manager, in exchange for a rebate if performance fell below a certain level.

And passive funds now account for 24% of assets under management, according to WM UK Local Authority Fund Annual Review. That's up from 14% ten years ago. So hard as it may seem to believe councils are learning.

Watch your costs and take charge of your money

But what does this tell you about your investments?

Firstly, it shows the importance of keeping an eye on costs. Why pay more than you have to for exactly the same performance? We keep hearing that we're facing a new normal' where future returns are going to be lower than they have been in the past. If you can only expect low single-digit real' (post-inflation) returns from the future, then you simply cannot afford to pay 1.5-2% of that away in fees.

Now, I'm not sure I'm convinced by the new normal' argument. I suspect that canny investors will be able to hunt down decent returns in most conditions. It's certainly been possible in the past four years, even as the term new normal' has become a clich.

But in any case, whether the average return over the next decade is 1% or 10%, I want to keep as much of that as possible for myself. That means making sure that I'm not shelling out more than I have to for the services of brokers, fund managers or financial advisors.

Secondly, it illustrates the risks of having a middle-man between you and your money. No one cares more about what happens to your money than you do. So if you're going to hand over control to someone else, you need to make sure that they have an incentive to look after it properly.

The trouble with most active fund managers is that growing your money in the long run is not their main goal. Their main goal is to hang on to their jobs.

And the way to hang on to your job as an active fund manager is by making sure that you always slightly underperform the wider market. That'll keep you in the middle of the pack, and you won't be picked off come performance review time.

You do this by basically replicating your benchmark (so if it's the FTSE 100, you hold BP, Vodafone, Glaxo, etc) and tinkering around the edges. All your tinkering will most likely detract from, rather than add to, your performance. And overall, your returns will be no better (and likely worse) than a cheap tracker fund.

But you won't get fired.

This poor alignment of interests is why I'm generally sceptical of active management. I'm not saying there's no place for it in your portfolio, but you'd have to be very picky. And I also believe that asset allocation (the sector where you put your money) is more important overall than individual stock-picking within that sector.

So rather than chasing the hottest fund managers, you should be working out which sectors you want to split your money between, and then looking for the cheapest ways to invest in those sectors. This will usually involve buying a passive fund which merely 'tracks' the performance of the underlying index, rather than ostensibly trying to beat it. This is the strategy my colleague Phil Oakley follows in his Lifetime Wealth newsletter. You can find out more about it here.

Also, index-tracker specialist Phil Amery will be looking at some of the new exchange-traded fund launches from Vanguard in the next issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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