Great reads from around the web.

I can rarely recall such a busy time in the UK. Decisions are being made now that will shape the economy for years to come.

On education and fees, the great student riot has been covered to death elsewhere. Regular readers may remember I feel the problem is simply too many weak students doing too many pointless degrees, creating a funding crisis. I’m all for aspiration, but it has to be credible, not fanciful. The world only needs so many digital photographers and marine biologists.

Those hungry for more should check out A Grain Of Salt’s link below to see why the debts aren’t so onerous, and Simple In Suffolk’s hopeful suggestion that revolting students could at least kill off the heinous X-Factor.

Common sense has at least broken out on welfare reform. Three cheers for Ian Duncan-Smith’s single universal benefit plan (a flat tax next, please!) People need to support themselves, and to aspire to a better life, whether it be materially or in terms of some other lifestyle choice. That thousands spend 20 years or more in a paid-for council house living on hand-outs from the State would shame the founders of the Labour movement. There’s far more dignity to sweeping the streets or cleaning the drains then scrounging off those that do.

Finally, the stock market continues its steady advance, as the global economy (ex-US and Europe) continues to roar ahead.

Many Monevator readers rightly follow a passive portfolio strategy, which means rebalancing when appropriate and ignoring the noise.

But those who’ve tried to be clever (like me!) can’t afford to get the big calls wrong, and the last couple of years have been all about big calls.

In particular, any UK investors who timidly stuck to cash and ignored the recovery in the stock market from its March 2009 low has paid a steep price. Instead of excellent double digit gains, they’ve seen a loss in real terms, especially after tax, due to high inflation.

According to the Bank of England, inflation has been above target for over 40 of the past 50 months! With commodity prices booming, the economy picking up steam, and monetary policy still super loose, inflation still seems to me far more likely going forward than deflation.

The FTSE All-Share still looks reasonable value, although clearly no longer bargain basement cheap. In particular, 10-year Gilt yields are edging higher, while rising stock prices reduce the yield on the All-Share.

At some point the risk-free returns from Gilts will make the return on equities look expensive. But whether it’s in six months time or a decade, nobody knows.

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The Annual Management Charge (AMC) is one of the most useless terms bandied around the world of investing. It’s trumpeted time and again in the media, in errant fund screeners, and by online forum dwellers as evidence of low cost funds that are worth investing in.

But the AMC is as misleading as a price that doesn’t include VAT. The sting is in the final bill.

What is TER?

The Total Expense Ratio (TER) is the cost to look out for when comparing funds. It’s a FSA-approved measure1 that offers a more accurate picture of the annual operating expenses that drag down the performance of your investment.

These operating expenses include:

• Annual management charge
• Legal fees
• Administrative fees
• Audit fees
• Marketing fees
• Directors’ fees
• Regulatory fees
• The mysterious ‘other’ expenses (biscuits, perhaps?)

Unlike reading that list, the TER will never make you yelp with pain. It’s not deducted directly from your bank account. It’s a stealth cost: a percentage silently shaved off your fund’s investment return over the course of a year.

The lower the TER the better, although you’ll struggle to beat a TER of 0.27% on a UK equity tracker fund. A TER of 1% on a similar fund would be like daylight robbery with extra kickings.

What difference does the TER make?

As fund firm Vanguard put it in their own prospectus:

Even seemingly small differences in expenses can, over time, have a dramatic effect on the Fund’s performance

We can witness that drama like an episode of 24 by comparing the TER cost of two otherwise identical funds:

	Fund A	Fund B
TER	0.27%	1%
Initial investment	10,000	10,000
Annual return	7%	7%
Holding period	25 years	25 years
Total return	£50,952	£42,919

Fund B has been whacked for over £8,000 more in charges over the period. That cuts your return by a painful 15.77%.

This sort of needless loss can be avoided by choosing funds with the most competitive TER wherever possible. You can compare TER damage yourself using a fund cost comparison calculator.

The illustration above also shows why it’s important to deal in TERs not AMCs. For example, Fidelity’s MoneyBuilder UK Index Fund declares an AMC of 0.1%, which is nearly three times smaller than its TER of 0.27%. A difference guaranteed to knock your calculations out of whack if you listen to lazy journalists.

TER twists

Beware that TERs are not fixed. You can find the TER in the fund fact sheet or prospectus, but you’ll also find small print explaining the fund manager reserves the right to charge extra for any unexpected operating costs.

That’s because the TER is a calculation based on the previous year’s events. Published TERs therefore represent an expectation of costs rather than a guarantee.

Don’t expect listed TERs to be accurate when you’re screening for funds, either. I’ve yet to find a fund screener that’s 100% up-to-date, or above occasionally quoting the AMC. The only way to be sure of an accurate TER is by checking the latest fund literature.

Hidden costs not in the TER

Sadly for the weary investor, the TER is not the one-stop cost-shop it’s often thought to be.

Though it’s the most practical tool we’ve got for instantly comparing funds, TER doesn’t tell you anything about:

• Initial charges and exit fees
• Brokerage fees
• Bid-offer spreads
• Market impact costs
• Taxes (e.g. stamp duty)
• Interest on borrowing
• Soft commissions

You’d need to subject most funds to a forensic examination to suss the impact of that lot upon your costs. Happily though, there are some useful rules of thumb that help show the way. I’ll return to that in a future post.

Suffice to say, the passive investment strategies adopted by index trackers make them far less prone to these costs than active funds.

Take it steady,

The Accumulator

1. TER = Total Operating Costs / Average Net Assets [↩]

My post of the week, plus plenty more worth reading across the Web.

I can’t get enough well-argued explanations as to why UK houses are overvalued. These people might be as wrong as me, prices might (or more specifically, ‘do’, at least here in London) go up regardless, but at least you feel you’re wrong with the smart money.

True, that won’t keep us refuseniks warm when we’re 68 and forced to live in some huge commune/squat in Milton Keynes with a bunch of other people who posted evidence of prices falls that never really came at House Price Crash like a middle-class cargo cult.

But heck, you can’t take it with you.

So on the property theme, my post of the week comes from Alan Dick, a financial planner from Glasgow.

Alan writes (apologies for going straight to informal Christian names, but to use his surname seemed provocative):

Most of us apply dubious mental accounting to convince ourselves that we have made a substantial profit on property.

Unfortunately, this is largely an illusion. Much of the so called profit is actually just the effect of inflation. Anyone over 50 probably paid more for their last car than they did for their first house. As house sales and purchases are generally infrequent activities we have plenty of time to put on our rose tinted glasses and ignore the effect of inflation.

Alan has crunched data since 1956 on house prices, shares, government bonds and RPI inflation, which is summed up in the following graph:

Pretty definitive win for shares. It’s worth noting, however, that the mid-1950s was when the ‘cult of the equity’ took off in the UK; I wouldn’t expect share prices to outperform over all timeframes like this (though right now, after two bear markets in a decade, is probably as good a starting point as any).

On the other hand, Alan also offers supporting data from the US and – intriguingly – Amsterdam, where records going back over several centuries for the same row of highly-prized townhouses shows prices rose by merely 0.2% per year in real terms (that is, after inflation) across 350 years.

Houses cost a lot to maintain and update, too, and they’re illiquid.

On the other hand, they have the great advantage of being the only way the average person can safely borrow to invest – provided they pay a reasonable initial price when they do so. It’s the gearing from a mortgage that in fact produces the bulk of the returns for anyone who isn’t lucky enough to buy at the start of a house price boom (most recently the late 1990s, in the UK).

A fair price for property

So what’s a reasonable price to pay? Alan cites the famed US writer William Bernstein’s suggestion of 15x the fair rental value of a property.

That would put my London place I rent at about £300,000, which seems about right – still eye-wateringly expensive, but understandably so given London wages and housing restrictions – as opposed to the £450,000 that similar places around here sell for, which just seems bonkers.

Do download the PDF and have a read yourself (there is good US graph, too, and details of a 100-year bear market for US property!)

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