Beware this sleight of hand when investing in funds

I wrote here a few months ago about one of the many mini-scandals of the investment industry – the practice of charging the costs of running a fund to its capital rather than to income.  

The point I was trying to make was that the vast majority of the time, a large part of what is paid out to fund investors as income is not income at all. It is simply some of their capital being paid back to them.

This matters for reasons of tax and of transparency, but it also matters because it interrupts the flow of the miracle of compounding. Turn capital into income and you effectively rob yourself of part of your chance to build long term wealth. 

I have talked to Terry Smith of Fundsmith about this issue a few times in the past (it drives him mad) so I am pleased to see that he has now written about it too. A press release arrived from him this week making two excellent points.

The first is that an over-focus on investing in high dividend-yielding stocks is a mistake, for the simple reason that “we know of virtually no business that can grow without reinvestment”. It is therefore vital (assuming you are hoping for long-term dividend and capital growth) to invest in business that both reinvest their cash and generate a high return on that reinvested cash.” Nothing to argue with there.

His next point is exactly the one I tried to make: charging management fees to capital obscures the total return and as such is no more than a “sleight of hand”. Worse, it is one that allows managers to boast about producing high yields while depleting your capital.

Funds, or so Terry believes (as do I) should be investing for total return. And if investors want to withdraw more money from a fund than arrives as income they can do so – simply by withdrawing capital, or in the case of investment trusts, selling a few shares.

Obviously, Terry has a business to promote, so the point of him weighing in on the subject this week is to make us all aware of his new plan – to allow investors to say how much money they would like to withdraw from the fund on regular basis and to pay it to them regardless of whether it is capital or income.

This makes sense for taxpayers (remember, capital gains are taxed at a lower rate than income for most of us) and also removes the risk that the managers might be tempted by a “bias towards investing in over distributing businesses.”

This is a neat idea. Terry gets to compete head-on with the big income funds for customers; investors get the “income” they want; and Fundsmith gets to keep its investment philosophy intact. I wonder how long it will be before the other big funds move to get in on the same game.