The following is another guest post from our industry expert who prefers to remain anonymous in sharing these insider tips with us. While we’ll always want to hunt down the cheapest funds and the most cost-effective platforms, I think it’s worth us understanding all of the realities of the investing business.

Everybody hates platforms. What might surprise you is that fund managers hate platforms every bit as much as you do.

While private investors jibe at the costs, the annoying extra charges, and those exit fees, what bugs the fund managers is the difficulty and cost of actually getting on the damn things.

Like most businesses, platforms exist to make a profit for their shareholders.

Except that they don’t.

When the FSA, as it was then, commissioned a leading firm of accountants to analyse the industry in 2012 ahead of RDR, it revealed that only one of them made any money. (But that one did make a lot.)

So why do the others platforms do it?

A business on the margins

Initially many platforms began life simply as a way for fund managers to market their products and make lives easier for IFAs.

They started as a one-stop shop where IFAs could put all their clients’ investments in one place and just get one statement.

Pretty soon though, fund managers realised they could encourage intermediaries to sell more of their funds if they provided some encouragement, known as trail commission.

But now the FCA1 has decided the industry should be transparent about everything, and that has made life a lot more difficult. Even worse, this is happening just when low cost passive funds that don’t pay trail are getting more popular – and fewer people are saving anyway.

Because most platforms lose money, they don’t really want to do anything that might make them lose more, such as stocking a never-ending range of funds. So it is a battle to get a fund onto some platforms and may even involve the payment of a so-called shelf fee just to be included.

Others just point-blank refuse to host a fund they don’t think won’t sell.

Before committing to a platform it is therefore a good idea to see exactly how many funds they stock. It doesn’t help investors much if fund managers create low cost funds but they are not available on the platform of your choice.

Since investing is a game for the long term you want to be fairly confident that the platform will be around for the next few decades.

That is not easy to assess. Nevertheless it is more likely that the profitable ones will survive.

Those that are tagged onto fund management operations as a distribution mechanism might suffer the cost-cutters knife in a few years. If so, this could force investors to move funds and possibly incur costs such as exit fees or maybe even tax. At the very least it involves more paperwork – the very thing platforms were invented to minimise.

Behind the best buy list

Platforms are just there to facilitate investing and keep the process as simple as possible. They most certainly do not provide advice to the investor using them for execution-only.

That might sound odd though to people who see the list of recommended funds that so many promote, whatever they happen to be labelled.

Getting onto these lists is the Holy Grail for fund managers.

Once upon a time such a list might have been compiled through the sage judgement of a seasoned market analyst. However, fund managers soon realised that inclusion in such a list was well worth a good lunch, a game of golf, or maybe just an enhanced trail fee.

Quite why such a distortion of the word recommended – or whatever other euphemism is used – has been allowed to persist for so long by the FCA and its predecessor is a mystery.

Well, no it isn’t actually.

While it is true that some cheap funds are now included in such panels, most of the incumbents are heavily promoted, well known and, usually, the largest funds in such compilations.

After all, why should the platform or broker take a risk on its reputation when it can get an easy life by sticking with the big guns?

Those of an older generation may remember the aphorism; you never get fired for buying IBM – a phrase that emerged in the hey-day of big computing when no one was quite sure what was going on. Buying the market leader was a safe, career-enhancing move.

No platform is going to risk its reputation promoting new funds, especially if they are small and do not spend much on promotion.

Consumers might think that in the new post-RDR investor-friendly world that marketing budgets are less important.

Think again.

The new rules allow managers to assist platforms with marketing costs, such as mail shots. Who could resist the opportunity of getting someone else to pay for the postage and other costs of reminding all your clients that you exist and are ready to help?

If platforms didn’t exist, someone would have to invent them

Perhaps the worst aspect of platforms for fund managers is that they have no idea who their clients are. All they get is a figure for money in or out.

Not knowing exactly who your customers are is major handicap for any business. For one like finance that relies so much on trust, it is a near-fatal flaw and makes it even more impersonal.

But the unfortunate truth is that maintaining all those records, dealing with money laundering checks, sending out reports and dividends is time-consuming and expensive. Fund managers want to manage money, they don’t want to run databases and satisfy the FCA on dozens of different issues.

For all that stuff platforms fill a valuable role. We might not like them, but no one is keen of taking on the tasks they do and certainly not at the prices they charge.

See our table to choose between the different fund platforms.

1. Financial Conduct Authority [↩]

Good reads from around the Web.

You have until midnight tonight (5 April) to shovel any free cash into your ISA to make the most of your 2013/2014 allowance.

If you’re still reading then either you have already filled your ISA – well done – or you haven’t got enough spare cash.

Or you’re a silly billy. Because there is no advantage to holding any cash or investments outside of an ISA. Nada. Zip.

The Guardian has a summary of some of the best places to stash your cash, though I can’t say whether you’ll be able to get money into every one of them in the scant hours remaining. Some firms are faster than others.

Alternatively, if you’ve got a share ISA already open, double check to see if you’ve already filled it to the max this year.

Me, I load up my shares ISA within the first few days of every new tax year. Why waste a moment of potential tax-free compounding?

[continue reading…]

I am a fan of author Michael Lewis. I loved his book about jumbo-sized bond traders, Liar’s Poker, his book about jumbo-sized sub-prime mortgage bets, The Big Short, and even his now long forgotten book about the jumbo-sized dotcom delusion, The New New Thing.

So I’m sure I’ll enjoy Flash Boys, his new book about the jumbo-sized high frequency traders that today probably makes up at least half of all trading volume.

What I probably won’t be is outraged, aghast, or calling for immediate change.

This might surprise you if you’ve heard Michael Lewis saying the stock market is “rigged”, or heard from others that deep-pocketed high-frequency trading firms are hurting the little guy.

To my mind, if you’re a little guy and you seriously think you’re playing in the same game as the high-frequency trading firms, you’ve got much bigger problems to worry about.

The machines that run the market

I won’t rehash all the arguments about high frequency trading. It’s easy to Google attacks on these operators and others leaping to their defence.

Hugely simplifying, the charge against them – or perhaps the entire system – is that robot traders get to see your Buy order for shares before a traditional intermediary can match you with a seller, and so they can quickly zip about the system buying up shares to sell back to you at a small profit.

And also that this makes buying and selling shares theoretically more expensive for you than if the high frequency trader had never been in the way.

I say “theoretically” because we are a long, long way from the days of a rich old retired Army major phoning up his bank manager to discuss their last golf game and then buying a few Shell shares, and that manager calling a sleepy market maker on the floor of the London Stock Exchange, and the order eventually getting chalked up on a board somewhere.

Rather, the system is utterly dominated by software trading, spread across multiple pools of capital.

To put your order directly through in the old-fashioned way, you wouldn’t need to ban high frequency trading – you’d need to invent a time machine.

Nowadays it’s a digital ecosystem, or better still a jungle. Various kinds of so-called robot traders and other software systems are constantly competing to capture tiny fractions of basis points here and there.

It’s not far-fetched to say that a high frequency trading algorithm that intercepts your order might buy its shares from a software-driven rival who knew you’d place your order before you did!

Not literally, of course. But perhaps it read some headlines that inspired your actions or else saw some correlated price moves or it was triggered by one of the other tens of thousands of things that are constantly crunched and recalculated by these ‘quant’ systems.

And that’s just one trivial example.1

One result of all this digitization and capital chasing tiny returns is that in 2014, as a private investor, if I use my online broker to buy shares in, say, Shell, I pay £6 and the spread is infinitesimal compared to 30 years ago.

If this is being ripped off by a rigged system, let’s have some more rigging.

Don’t hate the players, hate the game

So it’s very hard to see how small investors like you and me are being ripped off when we place share trades.

The whole process is getting cheaper every year.

But that’s not really the complaint.

Instead, the argument is that institutional investors who buy and invest on our behalf – big pension funds, large fund managers, that sort of thing – are being “taxed” by these high frequency traders to the tune of billions, because they have trillions under management.

Now, there may well be some truth to that. However, it’s still not the number one problem for us to worry about.

Firstly, many if not all of these institutional players fill their orders via some form of software too, which potentially takes into account the high frequency traders. They’re not lumbering across green fields like bovine herds.

Secondly, remember the counterfactuals!

Here I think there is a strong argument that the liquidity and competition supplied by these trading firms has in aggregate helped to bring costs down.

Not for some particular trade made on some Tuesday, perhaps, but compared to where we’d be overall under a more restricted market.

But even if it has not done so – and you can read coherent arguments either way – it’s hardly headline news that financial intermediaries skim money off us when we enact transactions.

It has always cost money to buy shares. I don’t think it makes much difference to us if we pay tens of basis points to a market maker the old-fashioned way, or if we pay roughly the same split between two intermediaries along the way.

You’re still paying financial middlemen to get your shares. Heck, in the UK even the government takes a hefty 0.5%.

Save your outrage for fees and underperformance

With regards to the cost of our investing with institutions via active funds, a few basis points of return lost to a high frequency trading firm is neither here nor there.

Active fund investors could easily be paying 1% to 2% or more in total costs. If they’re really rich and gullible and they’ve invested via a hedge fund, they could be paying an extra 20% on top of that.

That is the sort of frictional cost that really adds up. It’s not so much skimming as lobotomizing your returns.

The frenetic trading activity of fund managers only adds to the problem. As they churn their portfolios to try to keep up with their benchmarks, they wrack up all sorts of costs, of which the tithe allegedly extracted by high frequency traders is just a small portion.

All this, plus the odds are high that you’ll get lower returns from an active fund than an equivalent index fund!

So if you want to save money when investing, stop tutting as you read Michael Lewis’ allegations and instead go swap your actively managed funds for tracker funds.

Of course it’s true that passive investors in cheap tracker funds would in aggregate be paying some money to high frequency trading intermediaries, too.

But index funds generally turnover their portfolios a lot less than the typical active fund. So overall, index fund investors will pay a much lower amount to the fallen rocket scientists turned trading software whiz kids.

Yet another reason to be smug if you’re a passive investor.

As for those outraged institutional investors, they’re probably mostly annoyed that someone else is skimming money off us that they could be pocketing for themselves.

Pick your fights

What if like me you’ve strayed down the dark path, and you’re an active stock picker – a buyer and seller of individual shares – yourself?

Well, as stated, I think you’ve no reason to complain about the cost of buying and selling shares. It’s generally got far cheaper over the years. If high frequency traders get rich, I don’t think it’s on our dime.

It’s true that small cap trading feels like it’s become a bit more costly due to wider bid/offer spreads, but I don’t recall seeing hard statistics on this. Either way, software programs designed to hold securities for fractions of a second have nothing to do with illiquid shares like these.

If anything, the wide bid/offer spreads on smaller shares is a reminder of what life could be like for all share trades if we did legislate away the competition to supply liquidity to the markets.

Regardless, if you’re one of Monevator’s surprisingly numerous fund manager readers, then by all means fight for your right to more basis points.

But if you’re an individual trying to pick shares, you’ve got much bigger fish to fry than worrying about high frequency traders:

You’ll probably lose versus the markets

This is the big thing to think about. I’m an active investor myself and I get the appeal, but in aggregate at least three-quarters and probably many more individual investors will be down versus an index fund after a few years.

If you’re day trading large cap shares, you’re a muppet

Anyone who thinks their edge over the City and Wall Street is that they can get in and out of big companies faster than the professionals is a clueless numpty.

If you’re trading based on short-term charts, you’re also a numpty

I’m prepared to believe some technical trading strategies work. It’s a big world, and maybe there are unicorns yet to be discovered, too. But what I am sure of is that any short-term technical signals affecting mid to large companies are going to be spotted, bought, and dumped by some quant’s $10 million algorithm before you’ve dusted down your copy of Murphy to double check whether you’re looking at a reverse bottom or a couple of elongated tits.

One possible edge we have is holding periods

There are superb larger companies to own, but you’re not going to churn/trade them better than a professional. But you can though commit to hold them through thick and thin when a fund manager who is scared of temporarily underperforming might dump them. Over time, this might be your edge if you’re good at picking the best companies. It also implies you should be trading very rarely, and thus you’ll be providing scant pennies to the robot traders’ benevolence fund.

You may have an edge trading small companies

I believe it’s possible for some individuals to trade a bit more frequently in the shares of smaller companies. (By frequently, I mean holding for at least weeks or months, not for hours.) These shares are much more illiquid, and they’re not followed by professionals because they can’t front run invest in them in size. This is one way I try to beat the market myself. Again, whether you win or lose will be unperturbed by digital highwaymen demanding a few extra basis points on a trade.

You should be thinking, not trading

Another way in which it might be possible to beat the consensus is if you’re very adept at predicting the fortunes of companies. Some academics say the market will predict better than everyone out there, others say Buffett is a business genius. I think Buffett is a business genius, but I don’t know about you or me. So this has potential as a strategy – and it’s another one that has nothing to do with trying to beat teams of Phds with millions of dollars of hardware set up next the New York Stock Exchange.

You should be buying value shares

I’ve sung the praises of value investing before. You get into a share that nobody wants, perhaps because the business is iffy, and then after a good few months if not several years, you sell it for more than you paid for it when feelings change. This process is almost by definition immune to algorithmic pickpockets.

I could go on, but you get the idea.

Leave them scrap it out

It’d be a real shame if the average person becomes even more scared of the stock market after stumbling upon this controversy.

Because unless you’re a multi-millionaire looking to actually invest in a high frequency hedge fund (in which case good luck picking a winner) I don’t believe this alleged rigging matters very much to your investing.

You should really be in cheap low turnover index funds. If you must picks shares, you should probably be concentrating on those that are small, illiquid and potentially overlooked, or else looking for companies where you believe you understand the business and its value better than the professionals and you’re prepared to hold for a long time to see if you’re right. Nada trading.

As for the big institutions, who cares if one bunch of socially useless bloated financial firms is ripping off another bunch of socially useless bloated financial firms?

It makes a change from them ripping us off.

1. It’s also why I laugh uncontrollably at bulletin board posters who claim to have spotted some telling micro-movement in a share price chart 10.30am and 11.45pm. Go back to sleep granddad! [↩]