Friction cost — the biggest single drag on your returns
Posted by Robin Powell on July 1, 2016
Most people have never heard of it. The industry doesn’t talk about it and you rarely read about it in the media. But friction, or frictional, cost is a concept that every investor needs to understand.
In short, frictional costs are the direct and indirect costs entailed in the execution of financial transactions.
Now you might be thinking, How complicated can it be to manage my money? But you’d be surprised. When you invest in a pension, a chain of up to 16 different “professionals” have to be paid. As well as the fund manager, there’s also the fund “platform”, researchers, brokers, the stock exchange, the individual settling the trade, the custodians of the fund and so on.
Typically, investors are only quoted an annual management charge. But they end up paying a far higher percentage, and it’s often almost impossible to work out what the final figure is.
This huge expansion in financial intermediation, and the opacity surrounding it, is explained in a new book, What They Do With Your Money, by Stephen Davis, Jon Lukomnik and David Pitt-Watson. They summarise the problem like this:
“The chain of specialists has reached a ‘reductio ad absurdum point’ where the people we entrust to act on our behalf have become so numerous that much, if not most, of their compensation comes from other agents, rather than from us directly.
“Each step along the way makes perfect sense, but there are a lot of steps.. and at each step there are numerous opportunities for agents to extract fees, often without our being aware of it.”
Anglo-American money management, the authors say, is failing the populations of both Britain and the United States. To quote the book again: “The finance industry is not designed efficiently to create wealth for others. It has become positively awesome at creating wealth for itself.”
Sadly, the warning signs have been ignored for years. Warren Buffett, for example, described in his letter to Berkshire Hathaway shareholders in 2005 how intermediation was spiralling out of control. Instead of just sitting back and sharing in the success of American business, he said, investors were being persuaded by ”fast-talking Helpers” to try to outdo everyone else. In the process they were handing over a large chunk of their returns to third parties who were adding little value and yet, regardless of how well or poorly they performed, couldn’t lose:
“A record portion of the earnings that would go in their entirety to (investors) – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers.
“Heads, the Helper takes much of the winnings; tails, the (investors) lose and pay dearly for the privilege of doing so.”
So, what’s the answer? As Jack Bogle, the founder of Vanguard said recently, what investors need now is greater transparency. We need the industry to break down all the different and fees and charges involved and to present consumers with a single pounds-and-pence, or dollars-and-cents, figure for how much it costs to invest in a particular fund.
Thankfully, there are positive signs that we are indeed moving towards greater transparency. in the US, for example, the new Department of Labor rules designed to tackle conflicted investment advice have focused attention as never before on how much investors are paying and how much (or little) value they’re receiving in return.
Here in the UK, there’s much greater awareness than there was about friction cost and the huge impact it has on investment returns. The Financial Times in particular should be commended for drawing attention to the need for greater transparency. Although it received precious little media attention, even David Cameron recently expressed his concern about the issue at Prime Minister’s Question Time.
Indeed this very day, 1st July 2016, may even turn out to be an historic day for UK investors. Today my colleagues and I on the Transparency Task Force are presenting to the Financial Conduct Authority a report we’ve compiled over many months on the frictional costs incurred by UK consumers. It lists more than a hundred different fees and charges, many of them hidden, that investors are paying.
The hope is that our report will persuade the FCA to include in the study on competition in UK asset management that it’s currently working on a requirement on the fund industry to act. The industry has talked about transparency for years. The time has come to do something about it.