Don't wait for the regulator – here's how to avoid being ripped off on fund fees

published 30 June 2017

170630-fund-fees-b — Fund managers make too much money for the FCA's liking

The UK's financial sector watchdog, the Financial Conduct Authority (FCA), has just published the results of a review into the fund management business.

I won't say it's a right riveting read, but it does yet again make some highly pertinent points about the financial industry overcharging left, right and centre. And this time it indicates more clearly what the regulator plans to do about it.

Of course, it will still take quite a while to put the recommendations into place.

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The good news is that you don't have to wait. You can quite easily avoid the worst rip-offs in the City already.

Here's how...

Asset managers make too much money

Asset Management Market Study

MoneyWeek

Money Morning

Simply put, asset managers make too much money for the FCA's liking. Competition is meant to drive down prices and drive up quality. Instead, investors are being charged the same high prices they were a decade ago (annual fees have averaged about 1.6% for ages and show no sign of coming down).

Asset managers' profit margins have averaged 36% over the past six years. That's a nice business to be in. Those margins shoudn't really be sustainable if competition is working in the sector.

So what does the FCA want to do about it? One reason that prices haven't come down is a lack of transparency about what funds actually cost. So the FCA wants a single all-in fee, so it's clear to investors what they are being charged, and easier to compare prices between funds.

This all-in fee would include things such as trading costs, which aren't currently included in the usual numbers you see quoted for funds.

This sounds like a sensible idea. An added bonus is that if trading costs have to come out of a fixed fee, then there's likely to be less trading. That would be an improvement, as it makes managers take a longer-term view.

Of course, all of this will take a while to put in to place, and there's plenty of room for dilution in the meantime. And some people think the reforms don't go far enough. Certainly, the impact on the share prices of asset managers was muted, which shows that the market felt the review was no tougher than expected.

The good news is that you don't have to wait for the FCA to do anything. All of the solutions to the problems of active management already exist for private investors like you and me.

How not to get ripped off by the City

Sometimes, it's a bad idea to buy a passive fund. For example, when a market is rampantly overpriced, then I wouldn't be keen to invest in it using a passive fund. However, I wouldn't use an active fund to invest in a rampantly overpriced market either. I just wouldn't invest in that particular market at all.

However, if you find a market that's cheap and that you want to invest in, then a passive fund should usually be the first thing you consider. If the market goes up, your tracker will go up, too. If you buy an active fund instead, there's no guarantee that it will prosper just because the wider index does.

Also, costs are the one thing you have control over as an investor. So keeping them as low as possible should be one of your priorities. Passive funds are generally a lot cheaper than active funds.

So, that's passive funds. If you're looking for an active option you think you've found an attractive strategy, headed up by a high-conviction manager, for example then my first port of call would be investment trusts. These are, in effect, actively managed funds that are listed on the stockmarket. You buy and sell shares in the investment trust as you would buy and sell shares in any listed company.

Investment trusts sometimes trade at a premium (the shares are worth more than the underlying portfolio) or more commonly, at a discount (the shares are worth less than the underlying portfolio). That can be appealing if the share price trades at a significant discount. But what's more important is that investment trusts have a decent record of outperforming the market compared to other active funds.

In short, you don't have to buy the overpriced, underperforming rubbish that the City is trying to sell you. There are already plenty of other options, even before the regulator gets its teeth into the industry. So just do a tiny bit of homework and you can easily sidestep all the problems the FCA has highlighted. And hopefully, in the longer term, you won't have to.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.