How the City gets rich at your expense
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This genius investor does dizzying levels of research to uncover...Half Price Shares!
August has been a tough month. You are probably fed up with puzzling over things like ‘sub-prime mortgages’ and ‘collateralised debt’; and wondering why commentators cannot just say ‘share prices have fallen’ instead of things like ‘the market has been volatile’ or ‘there had been a re-pricing of risk.’
But the good news is that you can ignore all this. All you need to remember is that the stock market has these setbacks from time to time. The symptoms are always different, but they always stem from greed and over-optimism in a certain corner of the economy of financial world. In this case it has been mortgage lending in the USA. The stock market will come through this crisis as it has come through all previous crises. And if you are wondering whether playing the stock market game is worth the candle, then this issue gives you several thousand pounds worth of reasons why it is.
Speaking at the annual conference of the UK Shareholders Association, journalist Alastair Blair posed the following question. If you invest £884 and the rate of return is 10%, how much would this become after 40 years? The answer is £40,000.
But if you make an annual rate of return of only 7.5%, the answer would be £15,950.
Now the relevance of this comparison is that a typical fund, managed by a City investment management company, will have fees of about 2.5% per year deducted from it. About 1.5% goes to the investment manager, and then there are other indirect costs such as dealing commissions, custody charges, accountants’ costs etc that take another 1%.
This is how the City gets rich. In the above example it has managed, over forty years, to appropriate about 60% of the investment return that would otherwise go to shareholders. Apply this to the billions of pounds worth of funds that are managed supposedly on our behalf, and you can see exactly how the City gets so rich at the expense of the rest of us.
In fact the outcome can be even worse than I have illustrated, because you might also be charged an up front fee of up to 5% on your initial investment. So if you send a cheque for £1,000 to a fund manager only £950 is actually invested, and the fund manager pockets the other £50. If you apply this to the above example your £884 becomes not £40,000 but £14,096 – a shortfall of 65%!
Fortunately for fund managers not many people understand the workings of compound interest. But this arithmetic does pose two questions. Do City funds perform so well that it is worth paying their fees? And if we decide to go it alone, how much will it cost us to manage our own portfolios?
And to answer the first question about the performance of City funds I have had a look at the latest issue of What Investment, a magazine that lists the performance of the full baffling range of 1,758 unit trusts that are all competing for your money.
These cover all ‘asset classes’ – i.e. bonds and shares in all markets, both UK and overseas, along with specialist categories like technology funds. The average return of all these funds over one year has been 2.8%. Over the last three years the average annual return has been a respectable 12.9%. But over the last five and ten years the average annual return has been 7.9% and 7.1% respectively. These are recorded after annual fees, although they exclude the impact of any up front deduction from your contributions.
I don’t think that a long term return of less than 8% is very good at all. Of course the performance from one fund to another varies enormously. But unless someone can come up with a way of identifying in advance which funds are likely to do well, this is not much comfort. In fact advisers regularly get this wrong. Ten years ago I don’t think many so-called experts would have backed the return from dull old European equities to beat that of exciting Technology and Telecom funds. And yet the former have returned 9.8% per year, while the latter have returned just 3.5% annually.
So if you are going to manage your own portfolio of shares and bypass the City, you need to beat 8% per year to make the effort worthwhile. By managing your portfolio sensibly, you can easily beat the professionals. And by doing so year after year, you can make thousands of pounds worth of difference to the value of your savings.
By Tom Bulford for the Daily Reckoning
Editor of Red Hot Penny Shares, Tom Bulford worked as a fund manager in London and Hong Kong for more than 20 years. Responsible for £2bn of foreign clients' money, he also launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, he keeps subscribers to his free e letter The Penny Sleuth updated on the latest small cap market news.
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