A common mistake we see investors making when comparing funds is the assumption that funds with buy and sell spreads are more expensive than funds without them. In this article we unwrap why this isn’t right, and in fact why spreads work to remove investors experiencing hidden costs.
Ins and outs of fund traffic: why buy/sell spreads are fair
Traffic is busy in most managed funds.
At any one time, there is usually a flow of investors scooting in and out of a fund as they pursue their personal investment goals. Some funds, of course, are busier than others; and sometimes the traffic queue is longer in one direction than another.
Either way, the traffic flow imposes a cost that is largely invisible to the investors travelling blithely in and out through the fund gates, and to those remaining inside.
However, managers – and, while they may not realise it, remaining fund investors – experience the in-out traffic as a tangible expense.
Anthony Edmonds, InvestNow founder, says when investors buy or sell funds the manager is obliged to buy or sell underlying securities, which inevitably triggers transaction costs (principally, brokerage fees).
“Global best practice is for funds to recoup these transaction costs directly from the actual investors entering or leaving the fund via buy/sell spreads,” Edmonds says. “Spreads allow managers to apportion costs equitably without reducing returns for investors who remain in the fund.”
“I know many investors see spreads as just another fee but actually funds that don’t charge spreads are doing their investors a disservice.”
He says the investor misapprehension about buy/sell costs is evident in forums such as Reddit, where people will often berate funds with spreads for being more expensive than those without them.
Unfortunately, some NZ managers exploit this misunderstanding by not disclosing how the absence of buy/sell spreads can be a drag on performance while marketing their products as ‘cheaper’.
“NZ is still a bit of the ‘wild west’ when it comes to spreads, with many funds not having them,” Edmonds says. “To date, the regulator (the Financial Markets Authority) has not required managers to explain the negative effect of a fund not having spreads.”
“It seems odd that managers who have spreads must explain why these create equity amongst investors, while those without spreads never seem to disclose the potential inequities that this can create for investors.”
But how do spreads – that appear to be an extra cost – deliver a fairer outcome for all fund investors?
Let’s consider two passive NZ share funds that are identical except only one has spreads.
For the sake of simplicity, imagine a new investor places $2,000 in a fund that currently holds $1,000 on behalf of existing investors.
To buy shares the fund will incur brokerage costs. If we assume these brokerage costs are 0.1 per cent and share prices are stable, the process would work as follows in a fund without spreads.
|Value of existing fund:||$1,000|
|Less Brokerage (0.1 per cent)||$2|
|New total fund value||$2,998|
Under this scenario, the new investor owns two-thirds of the total funds – or $1,998.67.
Now look what happens if this investor decides to withdraw the $1.998.67 in full – again without spreads.
|Total Value of fund||$2,998|
|Less Brokerage (0.1 per cent)||$2|
|New total fund value||$997.33|
Note the brokerage was only levied on remaining fund investors while the exiting investor received his (or her) two-thirds value of the fund without any transaction fees deducted.
“Interestingly, this means that the original investors lost 0.27 per cent as a result of these transactions,” Edmonds says. “By contrast, the investor who made the contribution and withdrawal lost just 0.07 per cent.”
Following the same process in a fund with a 0.1 per cent spread would impose the entry and exit transaction costs on the new investor while leaving existing investors no worse off.
“Obviously, this example simplifies the reality. But it does correctly illustrate how all existing fund investors suffer when there are no buy/sell spreads in place,” Edmonds says. “Over the course of just one year, for instance, funds will usually process many thousands of investor buys or sells. For long-term fund investors this can result in significant costs that get buried in lower returns.”
He says some managers dismiss the brokerage costs as a small price to pay given individual client cashflows tend to be tiny relative to the overall size of the fund.
“But that claim is simply not right,” Edmonds says.
Reworking the $1,000 fund example as above but with 2,000 new investors contributing and then withdrawing $1 each highlights the point.
Under this scenario the existing investors would incur total brokerage costs of 0.4 per cent (reducing the final fund size to $996) while the 2,000 investors who took their $1 each quickly in and out would face a loss of just 0.0001 per cent each.
“If there had been a 0.10 per cent spread, then the original investors would have been unaffected. But each of the 2,000 individual investors entering and exiting would have incurred transactions costs of 0.2 per cent,” Edmonds says. “This is clearly the technically correct and fairest outcome.”
Until regulators require NZ issuers to apply buy/sell charges, or provide guidance that they believe this is good practice, then some managers will continue to offer funds without spreads.
“Although it would be better if the NZ market uniformly used buy/sell spreads in line with global best practice,” he says.
Meanwhile, Edmonds says fund investors also need to realise that buy/sell spreads are a sensible traffic management solution not a roundabout way to charge fees.