| Layers of endless cost |
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| Written by Wilfred Ling | |
| Tuesday, 12 January 2010 | |
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If you are purchasing a product, there are tons of layers of endless cost that do not benefit you. Here is a breakdown of cost in investing in funds: 1. The underlying assets such as stocks and bonds have two inherit cost. These are impact cost and brokerage cost. For an illiquid investment, when a fund manager buys or sells in bulk, the stock price moves. The other is brokerage fees which the stock broker charges. Both brokerage fee and impact cost is not reported but you can guess how much this is. It is quite typical for a fund to have more than 100% in turnover. This means that the entire holdings at the beginning of the year is sold and something else bought by end of the year. This will give you the magnitude of the high trading frequency that is occurring. I estimate that the brokerage fee is about 0.8% per annum of a typical fund and impact cost is about 4% per annum. 2. Fund charges a management fee typically it is 1% - 1.5% per annum. Also there is a trustee fee. But trustee fee tends to be small if the fund size is large. I estimate that half of the management fee is given out as trailer fees to the distribution channels. 3. Bid-offer spread. I am not referring to the sales charge of unit trusts. Instead, stocks and bonds’ buy and sell price are not exactly the same. This spread is translated to a cost to the fund that actively buys and sells. I estimate the cost to the fund is 2% per annum. The above cost will add up to 0.8 + 4 + 1.5 + 2 = 8.3% per annum. That’s not the end of the story. If you engage a financial adviser, you need to pay sales charge (about 1%-3%) and wrap fee (about 1% per annum). Some unethical adviser would churn their clients’ portfolio buy frequent buy sell as if they are like the top notch fund manager mentioned in (1) above. Assuming a constantly churning of every month, this cost will reduce your initial capital of $100,000 to $69,384 (assuming 3% sales charge for each switching). Of course majority of financial adviser will do a proper job of proper asset allocation with buy and hold methodology. Assuming buy and hold, the sales charge is only a one-time sunk cost. But the recurring cost is the wrap fee. Why need to have wrap fee? It is because the adviser needs to earn a living servicing the client. Majority of the trailer fees have been eaten up by those higher up the food chain. So there are hardly anything left. The wrap fee is the adviser’s own management fee. Of course, he doesn’t take the entire wrap fee because part of it needs to be shared with the immediate bureaucrat above him. Therefore it is my estimate that the total annual (recurring cost) is 9.3% per annum after taking into account of the wrap fee. This cost can be even higher if ILPs are used. Besides the insurance cost, there is the admin cost. I saw a case in which the client pays $120 per month in the ILP but is charged $25 per month of admin charge! This is not the insurance cost and also not management fee. It doesn’t seem to be commission too. This is crazy to spent more than 20% away in some admin fee! A better way is to forget about these active managed funds and invest in low-cost funds like ETF. If you can DIY, the cost I estimate for ETF is 1%. If you need to get some help from adviser, you can pay him 1% per annum. It is better to pay a total of 2% per annum than to spent 9.3% per annum! But of course, it is not possible to have a “wrap fee” over ETF because the platform providers will not provide such service. Why? Because ETFs do not pay trailer fees. Since the platform providers earn a significant amount from trailer fees, they will not provide ETFs. Therefore, clients have to pay this “wrap fee” for ETFs by cheque to their advisers. But this is a problem – both advisers and clients seem to have a mental block that paying cheques for servicing seem to be unacceptable. |
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