The hidden cost of active management

Most investors are aware that a fund's annual management charge (AMC) doesn't include all of its costs. Other expenses, such as administration costs, custodial fees for holding the fund's investments and legal and audit fees, are usually levied on top of the AMC.

For an actively managed fund, this can easily add another 0.15-0.25 percentage points to their expenses.

But you may not realise that even the ongoing charge figure (OCF) also known as the total expense ratio (TER) that includes all of these will still understate the true costs of your funds. That's because the OCF focuses solely on expenses that are expected to recur steadily each year and excludes one-off costs.

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In particular, the OCF doesn't include the fund's trading costs, since each trade is a one-off and total trading expenses will vary over time.

Yet, we know that almost every fund will incur some level of trading costs every year. For funds that have high portfolio turnover or invest in markets that have high transaction costs, the impact of trading costs can be very significant.

The true cost of trading

Most measures also look at bid/offer spread the difference between the price at which you can sell or buy. Some calculations also include price impact the effect that carrying a large order has on the market price of the share but this is an estimate rather than an exact cost.

The most detailed study is a 2013 paper by Roger Edelson, Richard Evans and Gregory Kadlec, which looked at a sample of 1,758 US equity funds between 1995 and 2006.

They found that the funds had an average expense ratio of 1.19%, but average annual trading costs were 1.44%. Their estimate of price impact accounted for the largest proportion of total trading costs; excluding it, costs were 0.49%.

Of course, managers run up these trading costs, because they're trying to outperform the market. If they succeed, the costs should be worth paying.

Unfortunately, the results don't bear this out.The study also found that funds with higher trading expense were associated with worse performance. On average, the most active managers weren't skilful enough to overcome the drag of higher expenses.

What does your fund spend?

The good news is that UK fund managers are coming under increasing pressure to disclose more of their costs. While you'll still only find the AMC and OCF on most fund fact sheets, many major houses are quietly publishing details of their trading expenses.

These can usually be found in a document called Enhanced disclosure of fund charges and costs', which is often tucked away in a corner of the fund manager's website.

This is well worth seeking out, since you may be shocked at how high some of your funds' trading expenses are after reading it.

What do brokerage commissions really pay for?

This was known as soft commissions, or 'softing', and allowed managers to pass some of the firm's costs directly onto the funds they managed.

Softing was banned in the UK a decade ago, but paying for research was excluded from the ban. So, many fund managers still pay for the broker research they receive through commissions that are higher than they need to be.

For example, a low-cost UK equity tracker might pay 0.05% for a trade, but a managed fund might be paying 0.15% for the same trade to get access to the broker's research.

The regulator is currently cracking down on abuses of this exemption. Some managers have been paying for corporate access (setting up meetings with management)in the guise of research, but this will be banned from 2 June.

Yet, supporters claim that the practice benefits everybody by supporting a large analyst community and allows small funds access to their research on the same basis as large ones. This argument isn't entirely convincing, however, given that the current system doesn't seem to work that well anyway.

Many fund managers say they only read a fraction of the research they get each day. That suggests they are paying for a huge body of work that they don't need. The allocation of resources in research under which you can have 40 analysts covering BP and none at all covering large swathes of the small-cap market is not very efficient.

And at root, investors in large, high turnover funds that pay lots of commission are subsidising smaller funds sometimes even funds managed by the same manager.

Overall, it's hard to see why anybody would design this system if they were starting from scratch.