Some good reads from around the web.

You can’t keep a bad idea down in the financial services industry – like Hindu vetala, the same ruses, obfuscations, and scams keep resurrecting in new forms to haunt us.

Well, that’s if the service providers in question have any sense of irony. Clearly that’s lacking at The Royal Bank of Scotland, who’ve decided to resurrect a controversial idea in the form of… the same controversial idea.

Barely a fortnight ago, Barclays was fined £7 million for investment advice failings, which basically amounted to calling funds ‘cautious’ and ‘balanced’, which the average consumer hears as ‘safe’ and ‘secure’.

So I was pretty surprised to get a press release from RBS that kicked off:

Today, the Royal Bank of Scotland will launch a major push into the retail fund management sector with the launch of two new funds (Cautious Managed and Balanced Managed) that have competitive charges, and aim to manage volatility to below market averages.

*Splutter!* What gives? Had RBS already spent so much on paperwork and logos for the new funds that it decided a fine of £7 million was a small risk to take?

Then we get to the money shot:

The Cautious and Balanced Managed sectors are among the most popular with IFAs and retail investors.

Ah, now I get it!

Moving on, RBS explains its strategy with the new products as follows:

The bank will be using a unique combination of strategies around diversification, trend analysis and volatility control to deliver its new propositions.

Here the news is a little better. Regular readers may recall me moaning about structured products in the past. I was happy (and not a bit surprised) to see that these funds simply offer regularly rebalanced exposure to the standard asset classes, with no derivatives linked to the value of the FTSE in 2015 or what have you.

But as the FT points out, the cautious fund could hold up to 51% of its money in equities, while the balanced fund could hold up to 81%. These may fit the current guidelines for those labels, but they don’t seem wise after the Barclay’s ruling.

Finally, the 1% annual charge isn’t the worst offender in the world, but all that rebalancing could result in a higher and somewhat hidden Total Expense Ratio.

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A tired but trusty metaphor for policymakers using interest rates to control inflation is that it’s a bit like pulling a brick across a table with a rubber band.

Think about it: Pull, pull, nope, nothing, “Are you sure this rubber band is really attached to it?” then – WHAM! – a brick flying towards your face.

That’s inflation for you. It can ramp up far faster than expected, and it’s non-trivial to stop it once it does.

A little bit of inflation is considered good for an economy. By slowly eroding the value of money, it forces those who have it to put it to productive use, rather rather than hoarding it under a mattress (or in gold for that matter).

Inflation is also favoured because the alternative – deflation – is a nasty and unsolved problem in economic policy. Just ask the Japanese.

Finally, governments like inflation because it erodes the value of outstanding public debt, and with far fewer complaints from voters than the alternatives of raising taxes or cutting spending.

But high inflation can be ruinous to investors, and really high inflation can wreck entire countries.

Inflation ahoy? Who knows

You may be reading this in February 2011, or you may be reading it in 2020, or on any day in-between. Whatever the date, I guarantee that someone out there is writing that inflation is about to go much higher.

Like the poor, the fear of inflation is always with us. Sometimes it proves well-founded, and the various mooted causes – rising commodity prices, excess liquidity, low interest rates, labour shortages, and many more – turn out to have been spot-on.

At other times, the trigger – low unemployment, say – doesn’t produce the inflationary spiral that the inflation-wary expected. The first decade of the 21st Century was much like that.

But it’s no surprise to me that it’s so hard to predict inflation. Our main tool against it is interest rates, and interest rate expectations are intimately linked with government bonds.

If you could know with any degree of certainty that high inflation is on the way (or, equally, that it’s definitely not) then you could capitalize on it by buying or shorting government bonds.

It’s a very simple trade, with few other risks associated with it – unlike investing in shares or corporate bonds, say.

For that very reason, tens of trillions of dollars is wagered in the government bond market worldwide, utterly dwarfing the equity market. This bond market sucks up the brainpower of thousands of smart people who are paid a small fortune to guess the direction of interest rates.

If you think you know better than this vast voting machine because, for example, you read on a blog that Mexicans are having a stand-off due to a tortilla shortage, then please get over yourself.1

Over the top inflation

Another problem for DIY inflation forecasters is that inflation has wicked feedback loops.

Fears of high inflation can become a self-fulfilling prophecy, as workers push for higher wages and consumers and companies start stockpiling. Alternatively, the prospect of higher interest rates to come to tame the inflation can curb spending and borrowing, and stop companies investing in expansion – even before rates have moved by very much.

Spare a thought for Central Bankers, who are tasked with having a monthly stab at it. The Bank of England got it right for a while, but for the past few years it’s overshot the target more often than an English striker in a World Cup match.

Perhaps that’s not surprising, given the recent climate: The usual mental Jenga of setting rates to try to influence inflation in 12-18 months time has been complicated by a financial meltdown that threatened to send us back to the Stone Age (or at least the gold standard). Mystic Meg would have got a migraine.

In 2009, for instance, I feared quantitative easing and record low rates would eventually spawn inflation in the UK (and loaded up on shares on the back of it) but it’s hard to prove the link so far. Yes, we have high inflation as I write, but it’s mainly imported through the weaker pound and higher commodity costs, topped off with the impact of VAT tax changes.

UK QE can be blamed for the weaker pound, but it hasn’t driven the oil price. And for its part the US has so far seen very little domestic inflation, despite its own massive QE operations and super-low interest rates.

But – and appropriately, for our American cousins, it’s a big but – the size of the US economy means in contrast it IS conceivable that cheap dollars are putting a light under commodity prices and emerging markets, and thus that US QE is fueling inflation that will be imported back home.

Conceivable, but so far unproven. All we know for sure is that inflation in the US has yet to spiral out of control, despite two years of pundits egging it on.

Well, apart from those many pundits who feared deflation, of course. I mocked them at the time, but as I said at the start you try to predict inflation and interest rates at your peril, so it doesn’t pay to be too smug.

Inflation always takes the house

In summary, sometimes the inflation hawks (those who want to raise rates to head off inflation) turn out to be right, and sometimes the doves (those who’d dial rates back because they don’t see any threat from rising prices) are the ones who can say they told you so.

History, as ever, remembers the winners. Still, that’s more than most bloggers, who seem to remember neither the winners nor the losers, but rather just that morning’s headlines.

Instead of being a hawk or a dove on inflation, as private investors we should play chicken to protect our wealth. This means having a healthy fear of the consequences of inflation, but not going crazy at every headline (that just makes you a headless chicken).

In particular, don’t let short-term stock market phobia cause you to invest too much of your long-term savings in low-yielding and/or fixed rate investments that have no ability to respond to inflationary shocks. Shares are much more volatile over the short run than bonds, but they more than make up for it by offering some protection from ever-rising prices over the long term.

In most of the world, for most of modern history, inflation has inexorably reduced the value of money over time, like water dripping onto an apparently impervious stone floor. It’s how your grandfather bought his first 3-bed house for £1,000, and it’s why your father thinks you spent too much on yours.

Drip. Drip. Drip.

Worried? Read my 10 ways to stop inflation eroding your wealth.

1. Note: I speak as someone who regularly does have a guess! I am only human, and not quite over myself. [↩]

Cutting costs is the name of the game for passive investors, so watch out for the effect of Portfolio Turnover Rate (PTR) on your trackers.

For all the focus on Total Expense Ratios (TERs) – the headline measure of a fund’s expense – they’re only the tip of the cost iceberg for products with a high turnover rate.

Portfolio turnover portends1 your fund’s exposure to stealth costs like:

• Bid/offer spreads
• Commissions
• Stamp duty
• Price impacts

These costs aren’t high on many investor’s radars, but they will together knock a chunk off your return.

What is turnover?

The portfolio turnover rate measures how often a fund’s securities are bought and sold within a 12-month period.

For example, a PTR of:

• 100% = the average asset in the fund portfolio is bought and sold every year.

• 50% = the average asset is bought and sold every two years.

• 200% = the average asset is bought and sold every six months.

PTR has a very simple cause and effect: The higher the PTR, the more often securities are traded, and so the greater the costs incurred.

These transaction costs can be broken down into:

• Broker commissions: The fees charged by brokers on every trade a fund makes.

• Bid/offer spread: The buying price of shares exceeds the selling price at any given moment. The difference is the spread, which is a profit mopped up by the market makers who facilitate trading.

• Price impacts: Funds that buy or sell shares in bulk will find the price moves against them as they try to complete the trade. This is because market makers are not obliged to make unlimited trades at their currently offered price and, for example, will hike prices in the face of a large buy order.

• Stamp duty: A 0.5% tax paid when UK funds buy shares. Happily, trackers based abroad don’t pay stamp duty, unless buying UK shares.

How much does PTR cost you?

Transaction costs are not included in a fund’s TER. A more accurate measure of a fund’s costs adds transaction costs on top of the TER.

This table from a Frontier Investment Management Research report shows how much portfolio turnover could be costing you:

As you can see from the table, transaction costs rise in less liquid markets such as emerging markets.

I recently bought a stake in iShares FTSE UK Dividend Plus ETF (IUKD), a volatile beast with value overtones. The TER is 0.4%, but turnover in 2010 was a whopping 241.41%.

According to the figures above, that turnover would have cost me nearly another 4%, or 10 times the TER. And IUKD won’t be as liquid as a large cap fund.

A rough rule of thumb for transaction costs is suggested by William Bernstein in his excellent book The Investor’s Manifesto:

0.1% of return is lost for every 10% of turnover.

Bernstein though is writing about the American market, which is more likely to benefit from lower transaction costs due to its higher liquidity.

From the table above, Frontier’s UK estimates imply that:

0.2% of return is lost for every 10% of turnover.

The median UK index fund has a turnover of 13%2, which translates into a hit of around 0.2%. Set next to a TER of 0.27% for cheap FTSE All-Share trackers, that’s a big extra slice off your bottom line.

Where do I find the turnover rate?

PTR’s generally lurk in your fund’s annual report. You’ll be able to find the latest report in the document section of your fund’s website, alongside the factsheet.

PTR’s can vary wildly from year-to-year, and from fund-to-fund, as this snapshot from iShares 2010 Annual Report reveals:

Trackers that capture a large part of the market like MSCI World tend to have a low turnover. Bond funds and equity funds that replicate only a portion of the market such as value, mid or small caps are likely to suffer higher turnover, as illustrated by the FTSE 250 and FTSE Dividend Plus ETFs.

Yahoo Finance also carries PTR info for some funds (click on Fund Profile and look for the Annual Holdings Turnover figure), although it can be out of date.

You can also pick up the impact of turnover rates if you check a fund’s tracking difference against its benchmark.

However you do it, just make sure you consider portfolio turnover when choosing trackers, because the TER doesn’t tell you everything you need to know.

Take it steady,

The Accumulator

1. Portend. Verb. To indicate in advance; to foreshadow or presage, as an omen does. For example: The street incident may portend a general uprising [↩]
2. Frontier Investment Management Research [↩]