Arbitrage is "practice of taking advantage of a price difference between two or more" .... of anything really. It doesnt make a difference unless the price difference is across A LOT of something e.g. 10p price difference per tin of beans, across 10,000 tins of beans (£1,000!), or unless it is done regularly.
Consider £100. It grows by 3% per year (what some people might consider the likely long term growth rate of stocks in the UK). Next year it is £103. The following year it grows again, not to £106 but to £106.09 - and the following year to £109.27. In the 37 years to my retirement it gets to £298.52 - so nearly three times as much. Pretty good, if it wasn't for the impact of inflation (which in late 2011 runs at more than 5%, so my pension pot is actually LOSING value).
But don't worry - there's dividends too. Those are payments that some companies make to their shareholders each year, out of the profits tha company makes. Tesco pays 4.06% in late 2011, British Gas owner Centrica pays 5.09%, and Google ..... well, it pays 0%. Let's say we are about (UK) average (US stocks tend to pay out a lot less), and we get paid a "yield" (i.e. the percentage of the share price) of 2.5% across all the shareholdings we own.
After 1 year our £100 has become £105.50, after two it's £111.30, after 3 it's £117.42 ..... all the way up to £725.01 after 37 years. We are in the money guys, and this is why investing your pension pot in company shares is a great idea.
Except hold on.....I am investing in the market through funds. I have to pay the fund manager. Suddenly that 3% + 2.5% = 5.5% per year needs to be reduced to take account of the fund manager charges. I learned about Total Expense Ratios (TERs) when I was trying to find out how much funds cost. One way of measuring them is the fund's own quoted Annual Management Charge but that seems to be a bit of a con - TERs are generally regarded as more representative. And the UK average TER? According to this Telegraph article it's about 1.6% (the article also says TER is also rubbish, but doesnt give a very acceptable alternative!). In Denmark, the cheapest in Europe, it's 1.49% according to this article.
So how does that affect my £100 over 37 years? Assuming the same growth (3%) and dividend (2.5%), in Denmark my fund manager would give me £428.33 back, and in the UK £411.88. I looked at my Scottish Widows TERs - one of them was 1.77%, so my £100 would only be worth £387.67.
I was looking at these numbers , side by side with this childish portfolio of random stocks recommended in The Week I was running through Google Finance. I was thinking about the guys with public school accents and hangovers. I was thinking, this is a complete joke industry.......
Who else sells you a service that causes you to lose almost half what it delivers you, without in many cases anyone even asking a question.
And the thing that drove me round the bend the most? Quantitative easing - Government-sponsored money printing (which always works) that made my funds worth loads more for about three weeks, then drop back in value again.
I decided that next time the Government announced it was printing loads of money, I was cashing in my chips at this metaphorical joint.....
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