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Cut costs with low turnover trackers

by The Accumulator on February 2, 2011

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 portends ¹ 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.

Leave no stone unturned in your search for hidden costs.

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:

iShares ETF	PTR
MSCI World	11.39%
FTSE 100	17.10%
FTSE 250	70.74%
FTSE Dividend Plus	241.41%
Euro Government Bond 1-3	298.99%

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

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

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Weekend reading: Pensions podcast

by The Investor on January 29, 2011

Some great reading from around the web.

For a second time this month, I’m going to make a Motley Fool podcast my post of the week. I hope it doesn’t go to their heads!

This new home run is an interview with Dr Ros Altmann, director general of Saga, the old person’s youth club.

Altmann is an expert on pensions, and it shows in her deep knowledge of how the system is still broken, why NEST pensions may be counter-productive, and why working for longer as much as saving more is going to be inevitable for most people (but not you and me, unless we want to!)

Here’s a snippet:

The money used to pay pensions today is funded by the contributions being made today. There’s no fund. National insurance is a myth – there isn’t a fund that you pay money into out of which your pension then comes. So the national insurance system is not working in the way people would expect it to work.

The level of state pension that is paid out is determined politically, rather than being, if you like, a function of proper calculations of life expectancy, actuarial equivalents, and so on. That again goes back to some of the problems we’ve got, which is that over the years the government has known that there are more and more people coming up for state pension age.

The baby boom generation has been around [for years] now, the first one is going to hit 65 this year, or already has, but the government kept pretending that it had sorted out the problem of funding pensions for all these people by using forecasts of private pension income that were completely unrealistic, and that weren’t adjusted sufficiently over time.

The whole podcast (which is also available in transcript form) is vital listening for anyone who wants to see the shape of retirement in 30 years hence.

[continue reading…]

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Subscription shares

by The Investor on January 27, 2011

A little known way to potentially increase your returns is to buy subscription shares.

These shares are effectively options on specific investment trusts.

A particular subscription share gives you the option – but not the obligation – to buy new ordinary shares ¹ in a particular trust by a particular date (the conversion date) at a particular price (the conversion price).

High risk, high reward

UK investors can buy subscription shares for the going market price through their usual stockbroker.

Occasionally, you may also be issued them by an investment trust that you already own, as sort of a bonus. You can then either decide to hold them, or else sell them in the open market.

Some examples include:

JP Morgan Emerging Market Subscription Shares (Ticker: JMGS)
Blackrock New Energy Subscription Shares (Ticker: BRNS)
Aberdeen New Thai Subscription Shares (Ticker: ANWS)

Each of these subscription shares offers geared exposure to the investment trust of the same name. I’m not sure exactly how many different ones are out there in total, but I’m aware of at least 30.

How do they make you money?

If you are holding a subscription share when its underlying investment trust’s price moves above the conversion price, then you can potentially make a lot of money (depending on what price you paid for the subscription shares). Returns of 3-4x the increase in the underlying trust’s share price are typical.

How do they lose you money?

If you own a subscription share where the conversion price is less than the underlying share price on the day the subscription share must be exercised, then your subscription share will expire worthless, since the option granted by it is useless (since nobody will buy it, because nobody will want to pay more than the going market price for the investment trust).

In-between these two extremes, you might lose some portion of your invested money if the underlying investment trust’s share price falls between you buying its subscription shares and the day those subscription shares must be exercised – but not by enough to render the subscription shares worthless.

Subscription shares are very risky investments. They are far riskier than conventional investment trust shares, let alone cash or bonds. Any investor must fully understand what he or she is buying, and be ready to lose all the money invested in them. For sophisticated investors only.

Subscription shares are not super simple

The maths may be relatively straightforward at first blush, but subscription shares still fail my KISS rule. Compare:

Normal investment trust shares: You are buying into a portfolio of shares or other assets, all of which have a market value. In most cases you can hold the trust for the long term to ride out volatility and benefit from the growth of those assets. You may also be paid a nice dividend.

Subscription shares: You buy the right to buy other shares, by some date. In plain speak, you basically buy a piece of paper with a promise written on it. Critically, you can’t hold on indefinitely to ride out any volatility, since subscription shares have a use-by date!

So the first kind of share is a time-honoured investment in a nicely diversified portfolio, the second is basically a bet on stock market prices.

I’m not saying don’t ever buy subscription shares – I own a couple myself – but please do be aware of the risks you’re taking.

Murky matters

Subscription shares also half-fail my suggestion that we avoid opaque or exotic financial products.

True, compared to guaranteed income bonds, subscription shares are probably superior – you can see all the prices in the open, buy and sell as you see fit, and take a view on the underlying trust’s investments.

But I’m not giving them a gold star, for two reasons.

First, as we’ll see in a future post, the maths is slightly complicated (though it’s easy to work with rough approximations).

Secondly, I don’t think there’s a good reason for subscription shares to exist!

As far as I can see, they are a wheeze dreamed up by fund managers to increase the total size of their funds under management.

True, existing shareholders shouldn’t lose out provided they hold onto any subscription shares they’re given AND they subscribe for new shares when conversion time comes (if appropriate). But I’m still not convinced the whole malarkey is of great benefit to anyone but the manager. ²

A safer way to take a high risk

Arguably though, that is all of academic interest to most investors. Most will buy their subscription shares on the open market and sell them if the price goes up, long before the conversion date becomes due.

What that means for shareholders in the underlying investment trust isn’t very relevant to such trading!

Subscription shares are a potentially useful tool for the advanced investor. They allow you to gear up your returns if you have a strong conviction about where the market is heading, while crucially your maximum losses are capped to the amount you invest.

I plan to post more on subscription shares in the weeks to come, so subscribe to get future installments. I’ll look at the maths of how subscription shares can magnify your returns, consider more of their advantages and disadvantages, and take a quick look at a few examples currently trading in the market.

Technically you get the right to subscribe for the new shares, hence the name.[↩]
Managers would also point out that a larger pool of assets under management usually reduces the TER. Which is true, but their fees still go up![↩]

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How good is your tracker? Use tracking difference to find out!

by The Accumulator on January 25, 2011

Knowing how closely your tracker hugs its benchmark index should be at the top of every passive investor’s To Do list.

Your chosen fund may have a dirt cheap Total Expense Ratio (TER), but if it lags its index by 2% a year then you’re paying a lot more for it than you realise.

No tracker perfectly delivers its benchmark’s returns. Tracking error is the measure that’s commonly used to describe and compare this deviant behaviour.

Yet the investment gods are cruel, and currently you’ll be hard-pressed to find many fund providers or independent investment sites queuing up to offer you tracking error data that can be meaningfully compared across all funds.

Try tracking difference

So when you’re choosing between trackers, you’re better off using a simpler measure that’s easier to find and use. Some call it tracking deviation, some call it trailing returns, and yet others call it tracking difference.

What we do know is that it’s a simple comparison of:

Total fund return Vs. total benchmark index return

For example:

If the Global Llama Volatility ETF (LAME) returns = 1%

And, its benchmark Llama Vol index returns = 2%

Then tracking difference = 1%

Whatever the TER says, that tracking difference provides a far more accurate description of the cost of owning that fund.

Tracking difference shows how well your fund matches its index

Check the tracking difference over:

1 year (minimum)
3 years (better)
5 years+ (you’ll be lucky)
A cumulative basis

Given the explosion of new trackers launched in this country over the past couple of years, it’s a struggle to find even three years of data to rub together for the average fund, so consider my wishlist as more of a forward-looking statement.

Look out!

There are plenty of pitfalls to trap the unwary investor seeking a simple tracking difference reading:

Make sure you’re checking like with like. The comparison is only meaningful if you’re pitting the tracker’s performance versus the actual index it tracks. You’ll find that information on a fund’s factsheet.

Data from Morningstar or Trustnet can be used but should be treated with caution as they regularly use the wrong index to benchmark a fund. Even a fund as straightforward as HSBC’s FTSE All-Share index fund is compared against the FTSE 100 by Morningstar.

You can chart your tracker against one of the more common indexes on Google Finance, Trustnet, or Yahoo Finance, but if the benchmark index is more unusual then these sites won’t enable you to dial up the right data.

Beware there can be a few different versions of the same index. Check whether your fund is meant to hug the Total Return version, or the Price Return incarnation.

So where do I turn?

The best source I’ve found to make tracking difference comparisons are the fund factsheets. They generally show the last 1-3 years performance against the correct index (assuming the fund’s been around that long), as well as cumulative performance.

Watch out for product providers who present this information before management fees. Comparing a tracker’s return against its index before subtracting a dirty great TER gives a misleading impression of how well the fund is doing and, more importantly, how well it will really do for you.

When comparing similar funds:

Choose the fund with the lowest tracking difference over as long a time period as possible.

The larger the performance gap between fund and index, the more flawed the product is. Even a tracker that’s trouncing its index is no cause for celebration. Trackers are designed to match the market, not beat it, so deviant performance simply shows the product isn’t to be relied upon over the long-term.

Chances are that the funds with the lowest TERs will also be the ones with the lowest tracking difference. But if you face a choice between a fund with a low TER and one that’s cheaper after tracking difference, then I’d plump for the latter.

Take it steady,

The Accumulator

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