What are you paying for?
While many people like to do their own thing when it comes to choosing investments, managing a large amount of capital can be daunting.
Keeping up with corporate events is an arduous business, and it is always a challenge getting your market timing right when buying and selling shares.
Despite the increasing amount of information on the internet, many people feel they lack the capacity to monitor and manage their investments.
You still need to decide on asset allocations and spread your capital among different managers even when funds or investment trusts are used. You will also need to keep up when investment managers change or decide what to do if a manager or a market goes off the boil.
Employing a professional to manage your money for you has obvious attractions. However, it will add to your costs.
There are considerable hidden costs involved in buying funds, and extra charges within product wrappers such as self-invested personal pensions (SIPPs) and structured products.
The same is true for discretionary investment management, where you hand your capital to a wealth manager or a financial adviser. They are not necessarily transparent on charging and the cost of platforms such as Cofunds and Transact is also something to be aware of.
Discretionary portfolio managers
Discretionary investment managers come in a variety of forms. There are the private banking arms of the high street clearing banks, private client stockbrokers such as Rathbones and Brewin Dolphin and specialist independent wealth managers such as Taylor Young Investment Management and Berry Asset Management.
Typically, these firms will quote an annual management fee for their services of, say, 1% or 1.5%.
However, they may levy a variety of other costs and charges, directly or indirectly, that can add considerably to the overall cost of having a portfolio managed. They tend not to make these explicit.
This aspect of the wealth management industry has been highlighted by one of the latest firms to join the field, Spencer-Churchill Miller Private, which was set up in 2009 by Alan Miller, former chief investment officer of New Star.
The company's declared aim is to challenge the traditional model of private client wealth management, particularly on the charging front.
Miller has been vociferous in his criticism of both the funds industry and fellow wealth managers for their hidden charges.
He says: "Fund companies may be bad, but wealth managers are even worse because they are so secretive and their charges so complicated. They make all the mark-ups known to mankind."
He says such mark-ups include rounding up exchange rates and keeping the difference when foreign shares are purchased.
Firms may also take a cut on the interest earned when clients' money is being held on deposit, thereby earning one rate but passing on a lower rate to clients.
It starts, however, with set-up fees and the charges companies levy when they take on a new client. Miller points out that 1% upfront may not sound bad. However, when this is added to the annual management fee, 2% or more of the portfolio can disappear in the first year.
On top of the annual management fees, extra charges may be levied for custody fees, valuations and tax "packs" that give investors the information they need to complete their tax returns.
Biggest hidden fee
According to Miller, the biggest hidden fee is the mark-up on share dealing costs.
He says: "Investment managers normally trade large amounts, so they will benefit from economies of scale and be able to deal at, say, 0.5% or less and add an extra 0.25 to 1% to cover their admin on top," he explains.
"They are not charging investors what they themselves are being charged. They are making a huge profit from dealing costs. This naturally gives them an incentive to deal more frequently, although they will, of course, deny this is the case."
Spencer-Churchill Miller Private uses exchange traded funds (ETFs) in its portfolios. Dealing charges on these funds are usually the same as shares.
However, Spencer-Churchill Miller Private has negotiated low bulk rates and passes on the actual cost to its investors. Miller says he has been unable to find any other wealth manager that deals at cost.
But Miller admits that determining other wealth managers' total charges is almost impossible. "When we researched the market we found it impossible to compare costs. Managers don't spell out their charges on their websites.
"They may be on page 242 of their terms and conditions, but even then they are often impossible to calculate. If we found it difficult, it is going to be a nightmare for ordinary investors."
Miller estimates that the ad hoc charges made by discretionary investment managers probably increase a basic management annual fee of 1% to between 2 and 3%.
His own firm charges 0.75% plus dealing costs, with no entry or exit commissions. It also makes a 5% performance charge from any annual gain.
One problem with this type of performance fee is that it does not require the firm to beat any particular benchmark or even make up for past losses. However, Miller defends it on the basis that it is clear and simple for investors to understand.
Make sure to ask questions
Investors who appoint a discretionary investment manager to run their portfolio will therefore need to ask a lot of questions to find out how much they will have to pay in the extra hidden charges.
David Bennett, chief executive at the Association of Private Client Investment Managers and Stockbrokers, admits there are no guidelines in the association's rules on how much managers should charge, either in annual management or ad hoc fees, and how these should be declared.
Pricing, he says, is "market-driven" and investors are free to shop around. But with unclear ad hoc charges, and no industry standard charging structure, it is difficult to see how investors can make rational decisions about whether their managers' fees are reasonable or not.
However, Bennett says: "We would argue that what really matters is whether investors feel their money is being well managed and they are happy with their investment returns."
Independent financial advisers
Investors without the minimum £500,000 or more that wealth managers usually require for their services may turn to an independent financial adviser to manage their money instead.
IFAs normally use investment funds for this purpose rather than direct investment in stocks and shares.
In theory, the trail commission of 0.5% per year that IFAs get from the investment funds they sell to clients should cover the cost of giving ongoing advice to investors.
Some do provide advice, but many simply pocket the commission and give little or nothing in return apart from leaflets with suggestions for further fund purchases.
Although there are no overt dealing costs to pay when buying and selling funds, there is normally an initial charge on a new fund that may be taken out of your investment. If an adviser relies on commission for his remuneration, the charge on each switch can be as high as 5%.
While some advisers may be prepared to forego their initial commission, there could still be front-end fees of 2%.
Paying a fee for investment management may work out cheaper in the long run for investors because there will be less incentive for advisers to "churn" a portfolio in order to gain their remuneration from the initial charges.
Fee-based advisers may charge an extra annual fee of up to 1% for active management of a fund portfolio, against which the trail commission will then normally be discounted.
Whichever approach is adopted, Robert Reid, director of Syndaxi Chartered Financial Planners, a fee-based firm of chartered financial planners, and a past president of the Personal Finance Society, suggests investors try to find out how often their adviser is likely to deal on their account.
"With advisers who go in for making tactical switches – buying and selling funds on a regular basis – investors' costs will be higher than when advisers adopt a buy-and-hold approach," he says.
Reid points out that an investor's costs may not necessarily be lower with an adviser who charges lower fees if this adviser trades an investor's portfolio heavily.
When the Financial Services Authority's retail distribution review is implemented at the end of 2012, all IFAs will have to start charging fees rather than relying on commission as they do at the moment.
Some advisers are finding it difficult to broach the subject of fees with investors, as they have never talked about money with their clients before, Reid explains.
Platforms and wraps
Increasingly, nowadays, investment advisers are holding client investments on platforms: third-party organisations that administer all of an individual's investment funds and other products in one location.
This makes it easier for investments to be managed and switched by avoiding the need to deal with each fund or product provider.
However, the platforms don't provide their services for nothing. Some platforms, at present, do not charge investors directly.
But investors do pay indirectly through their fund charges, as fund managers are charged by fund supermarket platforms, such as Cofunds and Skandia Selestia, for providing them with shelf space.
Typically, fund promoters have been paying 0.25% from the funds' annual management charges to the platforms.
So far, these costs do not appear to have impacted noticeably on the level of annual charges, as fund supermarkets have taken over some of the administrative work that was formerly carried out by the fund groups when they dealt direct with advisers.
However, there have been moves by some platforms, such as Cofunds, to increase the charges they make to fund groups to 0.3%, which could eventually be passed on to investors.
Other platforms function as "wraps", encompassing conventional investment funds and other types of investments and products such as ETFs, shares, bonds and structured products.
The wrap provider can also usually administer assets held in tax-wrappers, such as ISAs, personal pensions and a SIPP plan.
In such a case, annual fees are charged and passed on to the investor. Sometimes platforms bundle fees of 0.6 to 0.7% to cover all the services provided by a platform. Others take an unbundled approach and charge separately for items such as custody fees.
This article was originally published in Money Observer - Moneywise's sister publication - in April 2010
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
The difference between two currencies; specifically how much one currency is worth relative to each other. For example, if £1 is worth $1.50, converting sterling to US dollars, the exchange rate is 1.5. Converting dollars to sterling at those levels, the exchange rate is 0.66, so $1 is worth 66p. There are a wide variety of factors that influence the exchange rate, such as a country’s interest rates, inflation, and the state of politics and the economy in that country.
In a financial context, churn refers to the frequency at which a share portfolio or investment fund sells the securities in the portfolio to realise cash in order to buy more securities. It’s also a way unethical brokerage firms “churn” clients’ accounts by trading securities very actively in order to increase brokerage commissions rather than customer profits, as brokers’ income is directly related to the volume of trading they undertake on customers’ behalf.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.