Understanding the true cost of investing in multi-asset and multi-manager funds

The use of multi-asset funds has increased substantially in recent years. This trend has been driven by the desire to obtain long-term investment growth similar to that of equities, but with significantly lower volatility.

The presence of 'hidden' costs can make it difficult to assess the total costs of a multi-asset fund, particularly where more complex strategies are involved. The benefits of these strategies are often well articulated, but the costs are often overlooked.

The underlying costs of these funds are often overlooked, but should be a crucial factor in investors' selection process.

Looking beyond headline charges

The Retail Distribution Review (RDR) has served to make advisers and clients increasingly aware of how higher charges can weigh on long-term investment performance. Indeed, traditional ways of expressing charges, such as the annual management charge (AMC), may not give you the whole picture when it comes to providing a true reflection of the cost to the end consumer.

The total expense ratio (TER) and the more recent Ongoing Charges Figure (OCF) are more accurate measures of the total charges as they include items such as legal, custody and audit fees. However, even these measures only cover headline investment charges and do not capture the other costs of investing. When analysing a multi-asset fund, for example, investors may also wish to consider fund costs in three other areas:

  • the turnover costs of changing the funds held
  • the trading costs within the underlying funds
  • the cost of any derivatives exposure

Turnover costs of changing underlying funds

Trading costs are the most obvious example of costs that are not captured by the AMC, TER or OCF. While it's difficult to obtain precise figures, as fund turnover varies over time and from one manager to another, we believe that these are important costs to consider.

Switching exposure between asset classes or markets, for example by switching from UK to European equities, is one of the main ways that managers aim to add incremental returns. Even the most effective active manager won't be right with every trade, but each trade does incur transaction costs. These transaction costs are based on the difference between the buying and selling prices of investments (known as the 'bid/offer spread'). Where actively managed funds are bought as part of the overall multi-asset fund, it is also likely that there will be occasional costs from switching assets from one manager to another.

A multi-asset fund that uses inexpensive, in-house passive funds avoids the majority of these costs. It will therefore be likely to incur significantly lower costs than one using external active funds or Exchange-Traded Funds (ETFs). Furthermore, if managers have a wide range of liquid funds, the use of 'crossing' can help to reduce these costs further. Crossing is the in-house process of matching buyers and sellers of these underlying internal funds so that each side can avoid costs by trading at the 'mid' price.

Turnover costs within underlying funds

The funds held within a multi-asset fund also incur transaction costs. While both index and active funds incur these costs, they are typically much higher for active funds, as the managers change their views over time. This implies a considerable saving for multi-asset funds using index tracker funds for their underlying investment exposure.

Derivatives: The cost of flexibility

Most multi-asset funds use derivatives to take shorter-term positions that might be very expensive or time-consuming to undertake with physical assets. While derivatives can provide this important and useful flexibility, they can incur significant additional costs. Most multi-asset funds make use of both exchange-traded and over-the-counter derivatives such as futures, options, and total return swaps (TRS).

For example, exposure gained through futures and TRS tend to give a slightly lower return than the equivalent holding in the underlying asset. This is because of the funding charges banks generally make for providing them. These funding charges consist of the derivative funding cost, as well as the difference between the cost of the three-month cash rate (on which futures are based) and the lower cost of the one-week cash rate (against which most cash funds are benchmarked). There can also be costs relating to the clearing, execution and margin-interest costs associated with the use of derivatives.

When taking shorter-term positions it may still be more efficient to use derivatives than physical assets, due to lower initial trading costs in many cases. However, it is important to note the implied cost of assessing alternative strategies.

Making an informed investment decision

The combination of headline costs included in the TER and underlying trading and derivative costs can have a major impact on returns received by a multi-asset investor over the long run. However, the presence of 'hidden' costs can make it difficult to assess the total costs of a multi-asset fund, particularly where more complex strategies are involved. The benefits of these strategies are often well articulated, but the costs are often overlooked.

Assessing a manager's ability to generate returns and manage risk is clearly central to fund selection. When doing the due diligence research on a given fund for your clients, however, we also believe that it is crucial to take an in-depth look at all of the costs incurred in executing a fund manager's strategy.

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For further information about our Multi-Asset funds

T:  0345 070 8684*
E: fundsales@lgim.com
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The value of investments and any income from them may fall as well as rise and investors may get back less than they invest. *Call charges will vary.

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