21 Jun 2010 | Business

Strength in Numbers 

One of the key principles about investment trusts is that you can invest in a portfolio of shares at a lower cost than investing directly because you are pooling resources with other investors. This was as true in the 19th century, when trusts like SAINTS were set up by canny Scottish investors, as it is now.
 
When making an investment, there are several types of cost to consider: purchase costs to do with buying the investment – for instance, stamp duty, commission and any initial charge and then the ongoing annual costs like management fees and expenses, as well as possible administrative costs from holding shares, such as an annual product fee or broker portfolio fee. There may be costs from selling, such as commission, exit fees and the ‘spread’ (i.e. the difference between the buying and selling prices of the shares in the market).

The impact of all these costs over the life of your investment can be expressed as a ‘reduction in yield’ or RIY. In essence, this is the difference between the illustrative growth rate of the investment before charges and the actual growth after allowing for all of the costs listed above. The RIY is given in the Key Features document for any product through which you can invest in investment trusts.

An important component of the RIY, which grows in importance the longer you hold the investment, is the annual cost of managing the trust or fund. One possible advantage of pooling your investments with others is economies of scale. As a general rule, the larger the investment trust, the lower the operating costs as a proportion of the assets. These are measured by what is known as the total expense ratio (TER).

The TER is the total operating costs of managing an investment trust expressed as a percentage of its average net assets. Operating costs usually consist of two elements: the management fee paid (out of the assets of the investment trust) to the manager primarily for looking after the investments, and other annual expenses, including directors’ fees and other administrative costs deducted from the assets of the investment trust. The TER does not include the costs of buying or selling the shares or the cost of any advice.

For an investment trust you can calculate the TER by dividing the total operating costs (as shown in the Annual Report) by the average net assets and expressing the result as a percentage. So, a trust with average net assets of £100m and total operating costs of £1m will have a TER of 1 per cent; a trust with assets of £500m and operating costs of £2.5m will have a TER of 0.5 per cent, and so on.

The lower the TER is for a given portfolio, other things being equal, the lower the impact is on the investment potential. In addition, as total operating costs do not necessarily go up in proportion with the size of the investment portfolio, larger portfolios usually have greater economies of scale.

Costs can have a significant effect on returns – high costs eat into your capital, especially if they are compounded year after year. Generally, the TERs of large global investment trusts are lower than those of other actively managed pooled funds.

Of course, the RIY is the best way to compare the total costs of any investment choices you make. However, the theoretical illustration below shows how important the effect of the TER element could be.

If you invested £1,000 in a fund with a TER of 1.5 per cent compared to a fund with a TER of 0.6 per cent and assuming a growth rate of 6 per cent per annum over 10 years, all else being equal, the value of the first (higher charged) fund could be £139 lower. Over a longer period, the effect will be even more pronounced.

If you add in initial charges, the effect could be more dramatic. If we assume the purchase of an investment trust through the Baillie Gifford Share Plan with a TER of 0.6 per cent, stamp duty of 0.5 per cent and a sale cost of £22, and compare it with a unit trust or OEIC with a 5 per cent initial charge and a TER of 1.5 per cent, the figures over 10 years could amount to a difference of £186 – that’s 18.6 per cent on the initial £1,000. Bear in mind though that this is a hypothetical illustration and market conditions, inflation, spread, charges and terms can all change.

In practice, other things are never quite equal: performance will vary from manager to manager and fund to fund. However, in the current economic environment annual costs are an important factor to consider.

Read James Budden's BG Log piece on Total Expense Ratios

Robert O’Riordan is responsible for liaising with investment trust boards at Baillie Gifford and for communications with shareholders.

Investment markets, including currency exchange rates can go down as well as up and market conditions can change rapidly.  The value of any investment and any income from it can fall as well as rise and investors may not get back the amount invested.

The views given should not be taken as statements of fact and no reliance should be placed on these views when making investment decisions.