Among the many interesting items in the FCA’s bracingly good, if rather understatedly named asset management market study interim report, was a small piece on “risk-free box profits”.
This little gem makes its first appearance on page 129, as the second bullet point under paragraph 7.23. Quite justly, 7.23 is focused on identifying costs that are “not included in headline rates (such as the ongoing charges figure) and so are not as transparent to investors.” The biggest of these hidden costs – understandably occupying the first bullet-point in this section – is transaction costs.
Morningstar firmly believes that transaction costs should be included in the cost figure given to investors. Transaction costs can be thought of in two strands: explicit costs that are fees paid by funds to brokers to buy and sell securities, plus associated stamp duty; and implicit costs that arise from security prices moving against the fund as it trades, and any cost in foregoing trades that cannot be executed at an acceptable price because of such price movements.
Both are measurable costs that fund investors bear on an ongoing basis and should be clearly disclosed as part of any cost ratio. Furthermore, doing so might just have the salutary effect of giving portfolio managers incentive to trade as efficiently as possible.
Think about the phrase ‘risk-free box profits’ for just a moment. Would you like some risk-free profits? I would. Alas such things are fleetingly rare because in a well-functioning market they would be quickly arbitraged away. The reason they exist in this case is because the relationship between fund houses and investors is not a well-functioning market: one side (fund houses) holds a decisive information advantage over the other (investors), and in this case has used this advantage to quietly keep for itself money that was intended for another purpose. It’s as simple as that.
The issue arises from the dual-pricing mechanism used by most unit trusts, whereby the product will quote the price at which it will issue units and the price at which it will cancel them. The difference between the two is meant to capture any sales charge – less of an issue post-RDR – plus the cost of executing any trades needed to create or cancel units.
However, asset managers are often able to net out buy and sell requests against each other so that no trading is required to fill these orders, meaning that no costs are incurred. Yet in these cases, they still collect the ‘spread’ and pocket it as profit.
This is plainly ludicrous. Firms that use a dilution levy to compensate investors for the liquidity impact of trading in fund units are specifically banned from keeping the money as profit; as per the FCA Handbook, Coll 6.3.8.3, all such levies become the property of the fund. Because the spread on a dual-priced fund is not technically a dilution levy, it is not subject to these rules and so the unit trust managers are permitted to keep the money.
