Hidden Fund Fees Mean U.K. Investors Pay Double US Rates

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Pedestrians on the London Bridge on Oct. 11, 2011. Close

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Photographer: Chris Ratcliffe/Bloomberg

Pedestrians on the London Bridge on Oct. 11, 2011.

U.K. investors are paying twice as much for mutual funds as those in the U.S. and getting worse returns as a result of hidden fees costing as much as 18.5 billion pounds ($29.3 billion) a year, say industry executives.

Opaque fee structures, which exclude trading charges that can double the cost of owning a fund, make it difficult for customers to compare products and hurt competition, according to executives at Fidelity Worldwide Investment, Fundsmith LLP and SCM Private LLP. U.K. and European Union regulators are taking note and have already moved to ban some commissions starting next year.

“In what is allegedly a competitive industry, the U.K. funds market, how is it that the average cost of funds has risen over the years rather than fallen?” said Peter Smith, head of investments policy at the Financial Services Authority in London, the U.K. regulator. “That’s something we’re going to be thinking about.”

Faced with record low returns on cash and the closing of many company-guaranteed pension plans, British investors have flocked to mutual funds in the last three years even as hidden charges have dragged down performance. The fees paid to fund managers and passed on to brokers, traders and sales platforms have caused more U.K. actively managed funds to underperform their benchmarks than similar funds in the U.S., according to studies by the Vanguard Group Inc.

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Fund Sales Rise

“There’s a lack of competition” in the U.K. market, said Jack Bogle, founder of Vanguard in Valley Forge, Pennsylvania, the world’s biggest mutual fund manager. “People are taking a lot of time to wake up to the fact that the single most important factor in determining fund performance is expenses.”

Sales of U.K. mutual funds have reached 78.1 billion pounds in the last three years, 14 percent more than the previous seven years combined as the Bank of England cut interest rates to record lows, reducing returns on cash, according to the Investment Management Association, the U.K. fund-management trade group.

That’s a boon to British fund managers, whose mutual fund charges are more than double those in the U.S., according to academic research published by the Review of Financial Studies in 2009. The average British mutual fund charges 2.21 percent of its clients’ assets annually, compared with 1.04 percent in the U.S., the study said.

Equity, Bond Funds

Equity funds typically cost 2.48 percent in annual charges in the U.K. compared with 1.53 percent in the U.S. while bond funds cost 1.73 percent in Britain and 1.05 percent in America, the study said.

The research was conducted by Ajay Khorana of Citigroup Inc. (C) and the Georgia Institute of Technology, Henri Servaes of London Business School and Peter Tufano, formerly of Harvard Business School and now at Oxford University. “Our approach attempts to first tease out the national fee differences after controlling for obvious fund and complex characteristics,” the authors said.

The difference in fees means $10,000 invested in a U.S. fund growing at 5 percent a year would return $14,745 after 10 years, 12 percent more than the $13,167 returned by a U.K. fund growing at the same rate. The difference grows to 25 percent after 20 years and 40 percent after 30 years.

“People don’t understand how important fees are in terms of predicting performance,” Servaes said. “In the U.K., people are less aware of what they are paying. The disclosures are not as strong as in the U.S.”

Comparisons Difficult

The study found that countries with more regulations protecting investors such as the U.S. typically have lower fees. It included all costs that investors “could reasonably expect to pay,” Servaes said.

The inability to make apples-to-apples comparisons among funds in the U.K. damages customers’ ability to choose the cheapest products, said Christopher Traulsen, director of European fund research at Morningstar Inc. (MORN) Some funds include distribution and administration costs in their annual management charge and some don’t, he said. In the U.S., costs are standardized and easier to compare, he said.

“Customers are walking away thinking they’re paying one price but they’re actually paying much, much more in hidden fees,” said Gina Miller, co-founder of SCM Private, a London- based wealth manager founded in 2009. “Because there has been so little transparency, companies haven’t had to be competitive on price. The brokers, the fund managers and the platforms are making hay while the customer pays.”

Trading costs, performance fees and entry and exit charges aren’t typically included in U.K. funds’ advertised total expense ratio, said Terry Smith, chief executive officer of London-based interdealer broker Tullet Prebon Plc (TLPR) and fund manager Fundsmith LLP. That means British investors unwittingly pay 1.5 percent of their invested assets on top of their annual management charge, he said.

‘Ryanair’ Pricing

Fidelity, the second-largest mutual fund manager in both the world and the U.K., agrees. British fund managers habitually mislead investors through “Ryanair” style pricing, said Gary Shaughnessy, managing director of Boston-based Fidelity’s U.K. company. He was referring to Ryanair Holdings Plc (RYA), the Irish airline criticized by consumer groups including Which? for hiding fees, such as baggage charges, from their marketing.

“We’ve seen funds with a low headline price but then you’ve got to add the cost of the platform on, advisory fees on, trading costs on or the price only available for people with a quarter of a million pounds to invest,” Shaughnessy said. “If we’re going to regain trust from consumers, they have to see what the costs are on a like for like basis.”

Fidelity has a U.K. fund platform selling its own products as well as those of other firms. The company said it publishes all management, administration and distribution costs for all 1,200 funds from 90 providers.

U.K. Premium

The firm excludes trading costs in lieu of a “standardized way of reporting” across the industry, Shaughnessy said. The company only publishes U.K. fund holdings every six months compared to at least quarterly in the U.S.

The extra costs mean investors in U.K. mutual funds, which have 560 billion pounds under management, are paying 2.7 billion pounds on top of the advertised total expense ratio, according to research by SCM Private, which is running a campaign for more transparency in fund fees. That rises to 18.5 billion pounds if extrapolated to the U.K.’s 3.9 trillion-pound savings and investment industry, SCM said.

“Without doubt there’s just more transparency around fees in the U.S.,” said Morningstar’s Traulsen. “In the U.K., what they call a management fee might include all kinds of things. If you don’t know how much you’re paying and what you’re paying for, there’s a problem.”

U.S., U.K. Performance

The lack of fee transparency in the U.K. market means companies are unwilling to compete on price, Traulsen said. U.S funds are also more willing to pass on economies of scale to customers and have better governance that requires independent directors to negotiate down fees, he said.

A Morningstar study in 2010 showed that returns from low- cost funds beat high-cost funds in all asset classes and across all time periods tested.

“Expense ratios are strong predictors of performance,” Chicago-based Morningstar said. “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

In the U.K., the higher costs are worsening performance, according to Vanguard. About 74 percent of British active equity funds missed their benchmark FTSE All Share Index (ASX) over the past five years, according to data compiled by Vanguard. That compares with 57 percent of U.S. funds missing their benchmark S&P 500 Index in the five years to 2011, the data show.

Index Funds

A focus on costs in the U.S. has caused index-based funds, including exchange-traded funds to attract 2.5 times as much money from investors as actively managed funds in the past five years. Index-linked funds, excluding ETFs, make up 12.3 percent of the U.S.’s managed funds, according to the Investment Company Institute. That compares with 6.9 percent in the U.K., according to the IMA.

“I wouldn’t accept charges are double,” said Richard Saunders, CEO of the IMA, which represents U.K. fund managers. “I’ve not seen any credible evidence of that.”

While funds in the U.S. are cheaper than in the U.K., it’s because funds are bigger in the U.S. and more able to pass on economies of scale to customers rather than a lack of competition in the British market, Saunders said. Headline charges often look higher in the U.K. because brokers’ costs are often included in fund managers’ charges, making comparisons difficult, he said.

Broker Fees

Jane Bland, a spokeswoman for Invesco Perpetual, the U.K.’s biggest mutual fund manager, declined to comment. The firm’s parent company is Atlanta-based Invesco Ltd. (IVZ)

One reason U.K. fund managers charge so much is because they must compensate brokers and fund platforms for introducing clients, Fundsmith’s Smith said. So-called trail commission is capped at around 1 percent in the U.S., driving down costs, according to Morningstar’s Traulsen. There’s no cap in the U.K., he said.

Fundsmith doesn’t sell its 350 million-pound Fundsmith Equity Fund through Hargreaves Lansdown Plc (HL/), the U.K.’s biggest retail broker, because its trail commission charge is higher than similar firms, Smith said.

Hargreaves Lansdown has a 60 percent profit margin, the seventh highest in the FTSE 100 Index of leading U.K. firms, according to data compiled by Bloomberg. “That’s a pretty ritzy margin,” Smith said.

Hargreaves Lansdown

The broker charges about half of a fund manager’s annual management fee, which is no more than other firms, the Bristol, England-based firm said in response to Smith’s comments by e- mail. “It is cheaper to invest through Hargreaves Lansdown and most direct platforms than either using an independent financial adviser of investing directly with a fund group,” it said.

The FSA will ban independent financial advisers from accepting trail commission starting next January as part of its retail distribution review. Advisers will be required to take payment up front from the customer rather than be paid a continuing rate from annual charges from the fund manager.

“Products are designed and incentives put in place to buy distribution rather than to meet customer needs,” the FSA’s Smith said. “We see that as a problem due to conflict of interest and bias in the market that exists as a consequence.”

While the changes won’t initially lower costs to British investors, they will help customers see what they’re paying for and ensure they’re receiving unbiased investment advice, according to the FSA’s Smith and Saunders of the IMA. That will help investors become more aware of costs and increase competition they said.

U.K. ‘Changing’

“It has been fair to say the U.K. market in the past has not been as price sensitive as one might expect,” Saunders said. “That’s changing and will be given a further push by the retail distribution review.”

The RDR will supplement new rules from the European Union requiring funds to publish so-called key investor information documents, which will provide a region-wide standardized data on fund charges and risks. Those rules, which will be implemented later this year, replace the total expense ratio with a measure of continuing charges.

“Returns over the next 20 to 30 years, on the balance of probability, will be lower than the previous 30, meaning fees will only become a bigger and bigger issue,” Fundsmith’s Smith said.

To contact the reporter on this story: Kevin Crowley in London at kcrowley1@bloomberg.net

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net

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