Fees are taken from pooled investments in the following ways:
· One-off charges: so called 'entry' or 'exit' charges can be up to 5% but relatively few funds now levy them, and where they are levied they can usually be avoided by buying through a broker.
· Annual charges: typically between 0.75% and 1.25% for actively managed funds and between 0.25% and 0.85% for passive funds.[218]
· Trading fees and commissions: charged each time assets are bought or sold within a fund. A typical fund changes all assets every year, which can add 1.8% to the annual charges.[219]
Overall for an active fund typical annual charges amount to about 2.5%, with significant variations between funds. This is still high but lower than it used to be before the Financial Conduct Authority (FCA) changed the rules.[220] Nevertheless 2.5%, levied on the total investment in a fund every year represents a huge amount. It means that if a fund grows at an average of 5% per year - which is a good return - then about as much is paid in fees as is gained. One reason the fees are so high is because there are so many middle-men involved. John Kay gives a list in his book (Kay 2015 p207). They include registrars, custodians, nominees, asset managers, investment consultants, fund trustees, financial advisers, insurance companies, trading platforms, traders, stock exchanges and investment banks. All are very highly rewarded for their contributions.
Take an example: Say a wealthy father starts a fund with £100,000 for his daughter when she is born. When she cashes it in at the age of twenty-one at an average growth rate of 5% per year ignoring fees it would be worth £278,000 if all growth had been re-invested each year, but not all growth was re-invested, 2.5% was removed in fees each year so the annual growth she sees is only 2.375% and she only gets £163,700, with £70,400 paid out in fees.[221]
Is £70,400 a reasonable sum to pay for the service that has been provided? The fact that this sum is taken from growth, which is never seen by the father, makes it seem as though no money has been paid at all. In effect it is a disguised cost - and that is how the sector gets away with it. If, instead, the father decided to make the daughter a gift of £278,000 on her 21st birthday, but her bank told him that it had deducted £70,400 for making the transfer, he would probably faint on the spot. Clearly there are very significant differences in these two situations but they serve to illustrate the very different impact that a large unexpected charge makes on a person from an equivalent lower gain, especially when the gain was always going to be uncertain.
"People don't miss what they never had" - the unspoken rallying cry of the financial trading sector.
The factor that makes it easy to extract money for financial trading is that what the investor pays for is future hopes and expectations, which are magnified by distorted advertising. Traders sell expectations - very dearly - but are careful to ensure that failure to deliver carries no comebacks.
Let's take another example of a similar fund that grows at 2.5% per year ignoring fees. After twenty-one years it would be worth £168,000, but after fees it is worth £98,700 - a slight drop in value. Nevertheless the fund provider, managers and associated dealers and traders have taken £53,500. How's that for value? In this case the father would probably react badly because his money was worth substantially less because of inflation as well as the slight drop, even though the provider had taken less in fees than in the earlier case.[222]
The sector justifies its fees by the 'service' it provides and the 'expertise' that is applied, but we can judge the validity of these claims when we compare the 'experts' incomes with the incomes of similarly qualified people in other professions, when we find that they are several tens and sometimes hundreds of times more.
An estimate of the real value of fund management services can be made by looking at the charges for passive fund management, administered by computers rather than 'experts', which are of the order of 0.25% per year for the lowest charging funds.[223] This is still enough to pay all the providers' salaries and administration costs because they don't run funds at a loss. What investors pay is more than this by the amount of trading costs and commissions, but much of that cost is also extracted, so let's err on the generous side and add a further 0.25% for these services, giving 0.5% overall. This will also allow for government stamp duty which is payable at 0.5% of the value of all UK shares that are bought. Passive funds turn over their holdings very much less than actively managed funds so there will be considerably less stamp duty, trading fees and commissions to pay. But what about the salaries of fund managers? Well, since funds under active management do significantly worse on average than passive funds[224] it doesn't seem a good idea to pay people very well indeed just to lose other people's money. If any of those managers really do have exceptional investing skills then they can make a good living by investing their own money. There will still be a need for pooled funds and for fund managers, but there is no need for so many funds and therefore no need for so many managers, and certainly no need for such high salaries and bonuses - see the next chapter.
For the first example, growth after fees would be just under 4.5% and the amount returned to the daughter after twenty-one years would be £251,000. The amount paid in fees would be £17,700, which seems a much fairer price for the service, though still quite generous. That means that £52,700 of the earlier £70,400 had been extracted rather than earned.
For the second example growth after fees would be just under 2% and the amount returned to the daughter after twenty-one years would be £151,200. The amount paid in fees would be £13,200, which means that £40,300 of the earlier £53,500 had been extracted rather than earned.
From these examples it can be seen that overall wealth extraction by the financial trading sector is enormous. Taken together with wealth extraction by the banking sector and all the many other exploiters and ratchet services it is clear that wealth transfer from ordinary people to those who ride on their backs is vast. Additionally every one of the very many talented people employed in wealth extraction represents a wasted wealth creation opportunity.
This explains where all the money comes from that pays the enormous salaries of the armies of traders in Canary Wharf and elsewhere. Although they spend all their time trading against each other, which is a zero sum game for all players taken together[225], the money they make as a group isn't from trading; it's from the real-world earnings of investors in the funds, especially pension funds.
What financial traders do is to sell claims on future monetary returns, so it is easy to make claims that can't be refuted at the time they are made but can turn out to be hopelessly inaccurate. They are able to milk off a large share of any growth that does occur, and still make a handsome profit even if there are losses, all at buyers' expense. All the traders' protections and all the buyers' risks are very neatly spelled out in the small print of the terms and conditions drawn up by ranks of clever lawyers on the payroll.
How much wealth is extracted by the UK financial trading sector as a whole? David Craig (Craig 2011) maintained that it was £105 billion per year - £413 million every working day in 2011, but the fee structure was tightened by the FCA in 2013 and 2014 so it is probably less now, though still very substantial. For comparison purposes the annual cost of the NHS was £120 billion in 2016/17.
The situation in the US is very similar. Stewart L Brown of the Department of Finance at Florida State University wrote a very detailed paper in November 2016[226] in which he analysed all associated costs for pooled investment funds (known as mutual funds in the US), showing that they totalled about 2.6% of funds under management (Part V Section D Page 32). The subject of the paper was Regulatory Capture, costs to fund holders being one of the elements. This is the abstract:
Regulatory agencies are created to act in the public interest but often end up acting in the interests of those regulated. This is known as regulatory capture. The mutual fund industry is the custodian of massive levels of wealth of the investing public and is regulated by the Securities Exchange Commission ("the SEC"). Mutual fund assets are currently in the neighborhood of $16 trillion and these assets generate revenues in excess of $100 billion per year for the firms that manage mutual funds. The investment management industry is incentivized to influence the regulators by whatever means available to maximize profits for their owners. This paper documents how the investment management industry has captured the SEC in certain key policy areas. As a result, the industry is able to siphon off billions of dollars per year in excessive and often hidden fees. The SEC has within its power to unilaterally blunt the worse abuses if it were willing to act in the public interest.
The $100 billion figure quoted above is for fund management and is just one of the many costs borne by fund holders. In Part 7 of the paper he quotes US Senator Peter Fitzgerald:
The mutual fund industry is now the world's largest skimming operation - a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the Nation's household, college, and retirement savings.[227]
Part 6 of Brown's paper describes the attempts by Sen. Fitzgerald to bring into law the Mutual Fund Reform Act of 2004, which would have addressed the concerns. However in spite of being supported by both democrats and republicans it was killed by the chairman of the examining committee who used his discretion not to bring it to a vote.