At the time of writing (March 2006) there are 2002 funds (according to the Investment Management Association), 1324 of which can be placed in an ISA. You can choose from 118 ISA providers.
It’s hard enough for Independent Financial Advisers to keep abreast of the market, so we can’t imagine what it’s like for investors.
There are a number of factors to take into account when deciding which ISA manager and funds to invest with:
- Charges (initial and ongoing)
- Total Expense Ratio (measures ALL charges)
- Minimum amount you can invest
- Past performance
- Future potential performance
- Independent fund research
- Size of the investment fund (total £ in fund)
- Investment objective of the fund(s)
Let’s take a look at a few:
Charges (initial and ongoing)
Many funds have initial charges when you make the investment. A typical charge is 5% of the initial investment. So, if you invest £7,000 into an ISA, £350 will be swallowed up in charges.
If you invest via an Independent Financial Adviser, he or she may receive a commission payment of 3%. This is included within the 5% charge, usually referred to as the bid offer spread.
If you invest via the ISA provider directly, it’s usual practice for them to still deduct the 5% upfront charge. One way in which you can get around this is to invest via a discount broker.
They may charge you a low fee to set up the ISA (and rebate their commission), thereby possibly reducing the initial charge to approximately 2%.
There are funds available that do not have an initial charge. An example of this may be a tracker fund that charges 0%.
If you are investing monthly into your ISA it’s possible that you’re paying a 5% initial charge every month. This is avoidable and really you shouldn’t be paying more than 2%.
Total Expense Ratio
An investment fund’s total annual operating expenses (including management fees, distribution fees, and other expenses) revealed as a percentage of the fund’s average net assets.
High expense ratios decrease investors’ returns. An example would be two funds that both earned a 10% return before fees. If the first fund has an expense ratio that is 2 percent higher than second fund, you lose an extra 20 percent of your expected returns each year when your money is in the first fund.
The expense ratio does not include brokerage costs and various other transaction costs that may also contribute to a fund’s total expenses.
Past Performance
You’ve probably seen the warning in investment adverts that tell you ‘past performance is not a guide to future returns’.
And it isn’t.
But you’d be surprised by the amount of investors who invest thousands of pounds based on this one factor alone. The investment industry knows this as well. If you look at the adverts they all invariably promote the performance of the fund over the last 1, 3 or 5 years.
At the time of writing fund management companies are spending millions on publicity and adverts promoting their offerings. One of the reasons you’ll be seeing more adverts this month is that many share based funds grew by 20% or more in 2005.
So what should you do?
Look beyond the headlines. You need to know:
- What risks does the fund manager take? (volatility)
- What shares does the fund invest in?
- How long has the fund manager been in charge of the fund? (the average is 3 years)
- What other funds can I invest in if performance reduces?
Passive or Active?
There are bodies of research that point to investing passively rather than actively. This involves investing into funds that track the performance of the stockmarket, as opposed to using fund managers who try to beat the stockmarket.
Academic analysis of the sources of investment returns by Eugene Fama of the University of Chicago and Ken French of DartmouthCollege has reshaped portfolio theory and greatly improved understanding of the factors that drive equity (share) performance.
These are:
- Equity Market (complete value weighted universe of stocks). Shares have higher expected returns than fixed income.
- Company Size (measured by market capitalisation). Small Company Shares have higher expected returns than large company shares.
- Company Price (measured by ratio of company book value to market equity). Lower priced ‘value’ shares have higher expected returns than higher priced ‘growth’ shares.
In other words, research has found that differences in share returns are best explained by company size and price characteristics. Taken together, the three factors on average explain more than 90% of the performance of diversified share portfolios.
By investing into passive funds you’re able to:
- Reduce the costs of investing. Many funds have initial charges as low as 0%.
- Benefit from low management fees and operating expenses. Most active funds charge at least 1.5% pa, whereas passive funds charge 1% pa or less.
- Remove the need to switch funds through ‘churning’ as you remain invested in the market.
Let’s look at some additional factors for passive investing:
Lower turnover resulting in lower cost.
Most active investment managers do a large amount of trading, believing that this adds value. In the United States, one study showed that the average retail mutual fund had a turnover ratio of 83%, meaning that on average 83% of the securities in the portfolio were traded over a twelve-month period.
High turnover is costly to investors because each trade can incur stamp duty and other costs including commissions, spreads and market impact costs.
These hidden costs may amount to more than a unit trust’s total operating expenses if the fund trades heavily or if it invests in small company equities with high bid/ask margins. Institutional asset class funds have often significantly lower turnover because their institutional investors want them to deliver a specific asset class return with as low a cost as possible.
Consistently maintained asset class exposures.
Your long term objective will be best met if you keep your allocation within the initial parameters that you establish. Unfortunately, most retail unit trusts effectively have you relinquish your control of your asset allocation in their constant pursuit of the latest ‘hot’ stock or sector.
Institutional asset class funds do not have this problem because their mandates require that they must stay fully invested in the specific asset class they represent.
Conclusions
It can be argued that active management strategies do not consistently add value for the individual investor. Long-term investment objectives could best be achieved by maintaining a disciplined policy of asset class diversification within your overall risk parameters.
These goals can be best achieved by investing in institutional asset class vehicles for the long term, supported by regular rebalancing (adjusts your portfolio to maintain asset allocation).
Action Point
Take the time to do thorough research before you invest in your ISA. If you do use the services of a financial adviser, make sure they are creating a portfolio that is linked to your risk profile. There is a strong argument for using passive funds so include this in your research and ensure you monitor your portfolio at least annually.
The next post is the last one in this series and discusses how you should choose your ISA Manager.
