The costs and charges to be aware of when investing

The way you pay for funds is changing. Regulation that came into force at the start of the year as part of the Retail Distribution Review means financial advisers can no longer receive commission from fund management groups for recommending their products.

Before you get too excited, that doesn’t automatically mean buying funds has become cheaper. The overall costs might – in some cases – be lower but this isn’t guaranteed. In fact, you might actually end up paying more. The key lies in how the charges are expressed.

Until now, the various costs associated with buying funds – including the fund manager’s expenses for running the portfolio, fees for advice received and any platform levies – were bundled together with no clarity as to how much each of these services cost.

For example, out of the average 1.5% a year you were previously charged, the manager could have taken 0.75%, the adviser 0.5% and the platform 0.25%. The fact is no one knew for sure, which meant the whole process lacked transparency.

These charges are now being unbundled to make the system more transparent and easier to understand. It won’t happen overnight, of course, but it’s hoped in the years to come this will be viewed as a key change in the history of financial services.

The industry is making this transition through so-called ‘clean share classes’, which exclude commission. Using the example above, the 0.5% received by the adviser and the 0.25% from the platform would be removed, leaving just the 0.75% cost of the product itself.

It is then up to individual investors to negotiate with advisers and platforms – if either are required – to get the best deals. While it won’t necessarily make investing cheaper from day one, it will empower investors – particularly those with bigger sums to put away.

So where does that leave us? It depends how – and from whom – you buy a fund. The best way to explain the impact is by examining the three main ways investors can purchase funds: through execution-only brokers; direct from fund groups; and by using a financial adviser.

Execution-only brokers

At the moment, nothing has changed. If you buy a fund through an execution-only broker the charges are the same. That involves an initial fee, which has traditionally covered marketing costs incurred by the investment house, as well as any commission – but these are usually discounted to close to zero.

The annual charge is typically 1.5%. This is usually made up of 0.75% for the investment company, 0.25% for the platform and 0.5% for a financial adviser. Even though they didn’t give advice, they will generally still take the 0.5%. Execution-only businesses are still working on this basis today, although the Financial Services Authority is expected to eventually ban them from earning commission.

Direct from investment companies

Most investment firms won’t take your business directly for two reasons. First, they can’t be bothered with all the administration and, second, they don’t want to compete against their established channels of distribution, such as advisers.

For the few groups that do accept direct business, you typically won’t get any discount at all. You’re still likely to pay the full initial charges and the 1.5% annual charges. The fees designated for platforms and the adviser will also be kept by them, so going down this route can actually work out more expensive.

Financial advisers

This is where the rules have changed. The adviser charge and platform charge are both being stripped out of investment fund charges. If you purchase a fund through an adviser, the fund itself in its pure sense will have no initial charge and will only incur the investment fund charge.

However, if you go through a financial adviser, you’ll almost certainly have to pay for that advice and you can do that either by having charges added on to the fund or leave the fund as it is and pay separately for the advice received.

If you pay initial adviser charges from the fund, it would work out as follows: if you invest £10,000 and, for example, you agree your adviser will take an upfront fee of 2%, it will be clear that on day one your investment is worth £9,800 and the adviser has taken out £200.

If you pay annual adviser charges from the fund – at a fee of, say, 1%, the charges you pay will be added to the 0.75% investment manager cost, giving a total annual charge of 1.75%. If you are then using a platform that charges 0.25% each year, you can see your overall annual charge is 2%. It is transparent how much is going to each party.

Other charges to remember

It’s also worth pointing out that if you choose a fund with a performance fee that rewards the manager for returns above a certain level – there aren’t that many around but a number of the so-called absolute return portfolios have them – then they will still apply whatever route you choose.

Always consider other options before buying a fund that has the ability to levy a performance fee. At the very least, make sure you know what this watermark is and whether it is too easily achievable. The last thing you want is to be paying over the odds for a fund return that is mediocre at best.

What’s the cheapest way to invest?

You could try to avoid paying for an adviser, although you must bear in mind that you won’t benefit from financial advice, which means if it all goes wrong then you won’t have anybody to blame but yourself.

If you don’t need advice then shop around, as you can get a good deal from execution-only firms by seeing what’s available and examining the various terms. Cavendish Online, Alliance Trust Savings and Interactive Investor are usually among the cheapest.

You could try to negotiate lower charges with your financial adviser. However, you are only likely to succeed with this if you have bigger sums to invest as this will mean the adviser will be understandably keener to retain your business.

The future of fees

Over time, you would expect greater transparency to lead to downward pressure on prices, especially as investors become more empowered. That should certainly happen when execution-only businesses stop taking commission and are forced to use unbundled share classes.

However, there are still a number of questions to be answered. How will execution-only brokers be affected in the future? Will all fund groups launch clean share classes? Therefore, will it be months before we can judge the impact of the new regime on fees?

The best advice is to speak with your adviser – if you have one – or the fund management group from which you bought your fund, and ask them what is happening and how it is likely to affect you financially in the future. If you’re not happy then look elsewhere.

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