Stop fees eating into your investments
No one can expect to invest free of charge. There will always be costs involved. But it is important to know what those costs are otherwise it is impossible to make a properly informed choice.
Currently, the charges on many types of investments and investment services in the UK are anything but clear.
This is despite the Financial Services Authority (FSA) mantra to financial companies, in the shape of its "Treating Customers Fairly" initiative, that fairness on charges should be a key consideration.
In this article, I examine in depth the charges on actively managed "collective" investment funds: open-ended investment companies (OEICs) and unit trusts; and investment trusts.
These investment vehicles, which enable retail investors to gain exposure to portfolios of shares and other assets, are the most common building blocks for most people's investment portfolios nowadays.
However, their charging structures are not as transparent as they should be. Fund management groups are being less than open and not revealing the full extent of their charges. Actual deductions can be many times higher than declared charges.
This does not mean that the cheapest funds are necessarily the best. But paying higher charges does not mean investors will always get a better deal either.
Investors must be able to make these judgements for themselves and to do so they need to be given all the information in a clear and straightforward way so they can call investment companies to account.
Spoiling a good reputation
Until now, collective investment fund providers have generally been regarded as the white sheep of the UK financial services industry.
Insurance and pension providers have had a far worse reputation for lack of transparency and high charges, usually stemming from the exorbitant rates of commission paid to intermediaries.
This often resulted in low returns and heavy penalties when investment products were redeemed early.
As consumers became aware of the extent of overcharging on these old-style insurance and pension contracts, they increasingly turned their backs on them and have turned to investment funds instead.
Unfortunately, it is now apparent that some fund companies are not being as open about their charges as they should be and, instead of making their charging structures easier to understand, are making them more complicated.
OEICs and unit trusts - high charging facts laid bare
The worst offenders are OEICs and unit trusts, even though at first glance their charges appear to be straightforward, consisting of an initial fee and an annual management charge.
The initial fee is typically 5% and is designed to cover marketing and other distribution costs, including commission to financial advisers which is normally around 3%.
However, nowadays advisers are often happy to reduce or waive their commission so investors pay little or no initial fees.
Annual management charges (AMCs) are normally around 1.5 to 1.75%.
Among other things, this charge contributes to the cost of investment management and the annual trail commission of 0.5% paid to advisers, which is intended to remunerate them for providing an ongoing service to investors.
However, it does not cover all costs and companies calculate it differently. Charges expert Ed Moisson, head of consulting at Lipper FMI, says: "The AMC is not a 'clean' figure. In other words what is included is not consistent."
A more comprehensive and comparable measure of cost is the total expense ratio (TER).
Moisson says: "The TER is consistent and includes all operating costs that drag on fund performance each year - administration, custody, audit, management and distribution fees - while the AMC may or may not include some or all of these costs."
For this reason, the difference between a fund's AMC and TER can sometimes be minimal at just a few per cent (for example, from 1.5 to 1.6%), and sometimes a percentage point or more.
Funds of funds, for example, may quote an AMC of 1.5%, but after the costs of the underlying funds are taken into account the average TER is 2.21%.
Buried in the small print
Fund managers must calculate TERs for their funds but they rarely give them as much prominence in their fund literature as AMCs.
As long as they have included them in their "key features documents", which must be provided to investors when they first invest, then managers have fulfilled their legal obligations.
However, key features documents are long, closely printed leaflets that few investors are likely to read in detail.
Therefore, as an important first step towards transparency and openness, why aren't asset management companies compelled to give TERs much greater prominence in their fund literature?
Investors would then have at least one measure of charges that they can use for comparison purposes.
Although some funds with an overseas remit can have higher-than-average TERs, UK-invested funds feature among those with the highest charges as well as among those with the lowest. A global equity fund also appears in both categories.
Fund size can be another factor affecting TERs, with smaller funds suffering disproportionately from fixed costs. The three Premier Castlefield funds with the highest TERs, which are managed by Castlefield, a small investment firm, are all under £1 million in size.
However, the St James's Place fund is more than £35 million in size so it does not have that excuse. The average size of the funds with the lower TERs is higher.
Another distinguishing feature is that four of the five funds with the highest TERs are OEICs, while among the lowest charging the majority are unit trusts.
TERs on some OEICs are now being bumped up even further by the growing number of fund groups charging additional, so-called "performance" fees. These deductions are typically 15 to 20% of a fund's gains.
The fees, charged retrospectively, must also be included in funds' overall TERs. It is those funds with performance fees that are among those with the highest TERs.
Performance fees do not always sound much, but they can result in total charges of more than double the advertised AMC. For example, if a fund generates gains of 10% over a year and has a 20% performance fee, the fund managers can claim an extra 2% fee.
If it has a 1.5% annual management fee which, with additional running costs, becomes a basic TER of 1.65%, the addition of the performance fee will bring total deductions to 3.65%, leaving the investor with a return of 6.35%.
It is not just the size of the performance fee that is a problem but how it is structured. Most funds have some kind of benchmark they must beat such as a stockmarket index or an interest rate measure.
But the appropriateness of these benchmarks needs to be questioned as well as whether the performance fee will be applied to all returns or only those above the benchmark.
For example, is there a "high water mark" that means returns have to exceed previous highs before another performance fee is triggered? These details are usually buried in the small print.
Mark Dampier, head of research at independent financial advisers Hargreaves Lansdown, and a veteran of the funds industry, is against performance fees. "I don't like them because investors end up paying more for less.
They are based on performance benchmarks, such as interest on cash, which any fund manager worth his salt should be beating anyway.
"If investors were paying for proper outperformance it might be different. And one of the worst aspects is that they are taken out of funds at short intervals, such as yearly or even quarterly.
They are as bad as bank bonuses. If they were crystallized, say every three years, it would be more acceptable."
Another bone of contention is that most fund performance fees in the UK only have an upside.
As Lipper FMI's Moisson points out: "There is no clear evidence that funds with performance fees charge lower AMCs than other funds, and if they underperform there is also not an equivalent fee deduction, unlike 'fulcrum' fees found in the US, where this does occur."
Melchoir Japan Advantage, with one of the highest TERs at over 7.2% according to latest Lipper FMI information, has a performance fee of 15% of the outperformance of the Topix (the Tokyo Stock Price Index), plus a 1.5% AMC.
The Virgin Climate Change fund, on the other hand, measures its performance against bank base rate.
Virgin Money spokesperson Scott Mowbray says: "I understand why people might question this benchmark currently with base rate at just 0.5%, but the rate was considerably higher when the fund launched and we felt it was better to have a positive benchmark than an index."
As it is, in its latest accounting period, the fund clocked up the second-highest total TER, including a performance fee of 4.47%, according to Lipper FMI.
Another fund with a TER of more than 4% including performance fee is BlackRock UK Absolute Alpha, a popular new kind of absolute return fund, aiming to achieve positive returns in all market conditions.
But that's not all...
Even though the TER includes the word "total", it does not include all expenses. It does not, for example, include any initial or exit charges on a fund.
However, the impact of these charges, where known, plus the TER can be found in the key features document.
It will include an example of actual deductions based on a set investment growing at an assumed rate over 10 years and it also includes a statutory "reduction in yield" calculation.
Take, for example, the M&G Recovery fund. It has an initial charge of 4%, while its TER is 1.67%. The effect of these deductions on an investor's returns would be to bring investment growth of 6% a year down to 3.8% a year.
This calculation does not include the potential exit charge that investors can incur if they cash in their investment.
If this happens, the price of the fund can be adjusted to protect the interests of longer-term investors. With unit trusts, the exit fee is visible because it is reflected in a larger than normal spread between the buying and selling price.
But with OEICs, which operate on a single, mid-price basis, it is more difficult to detect as a dilution levy will be imposed which has the effect of swinging the price away from the mid price.
More hidden charges
Also not included in TERs are the costs associated with buying and selling shares within a fund's portfolio.
Alan Miller, a former fund manager at New Star, recently estimated that these costs would add a further 1% a year to the average TER on a unit trust or OEIC in the UK all companies sector, based on the average portfolio turnover rate of 57%.
By also spreading the impact of the front-end charges, Miller calculates the real total average cost of fund investment at 3.8% a year over a five-year period. He has called for these calculations to become the norm.
More recently, Miller has estimated that, on average, 26% of absolute return funds' underlying returns were removed through dealing costs, fund expenses and performance fees.
Peter Robertson, head of retail at Vanguard Investments UK, argues a similar point about dealing costs. Last year, his firm launched a range of low-cost index tracking funds that do not pay trail commission to advisers.
By removing this commission and setting a minimum investment of £100,000, the TERs on Vanguard's funds are well below average. Turnover on index trackers is also low.
Robertson believes UK investors should be told about transaction costs within funds. He pointed out recently: "In some EU member countries transaction costs are included in operating costs and European regulators insist managers disclose their portfolio turnover rate (PTR).
If you know the average transaction cost and multiply it by the turnover rate you can easily calculate a revised TER and this is the direction in which we should be heading."
He adds: "Turnover is a bigger issue in the UK, specifically in UK equity funds, than anywhere else in the developed world because of Stamp Duty Reserve Tax (SDRT).
Increasingly, transaction costs such as broker commission and spreads are usually very low - often just a few basis points - so SDRT at 0.5%, is the most of the transaction cost."
Investment trusts - room for improvement
So far this article has focused on OEICs and unit trusts, as they are the main type of collective funds bought by UK retail investors. But there are alternatives. One is investment trusts.
On average, they have lower AMCs and TERs. According to the latest survey by the Association of Investment Companies, nearly a third of investment trusts had TERs under 1%, excluding performance fees.
The average for the investment trust industry as a whole was 1.44%, compared to 1.66% for actively managed equity OEICs and unit trusts.
One of the main reasons investment trust fees are lower is that there is no commission for advisers built into their charging structures. So there is no initial charge, for example.
However, investors do have to pay something when they purchase investment trust shares and when they sell them.
Although a handful of investment trust groups sell trust shares to private investors free of charge, most make a charge of up to 1% when shares are purchased.
Alternatively shares can be purchased through a low-cost execution-only stockbroker or platform, such as Interactive Investor or Alliance Trust Savings, for a flat dealing charge of £10 to £20. Stamp duty - SDRT - is also incurred whenever investment trusts are bought.
There are also performance fees on some investment trusts which increases their TERs, although the lower basic fees still keep overall fees relatively low.
However, with many investment trusts that carry performance fees, maximum limits for overall fees are defined.
As with OEICs and unit trusts, investment trust TERs do not include any allowance for the transaction costs involved in buying and selling investments in the trusts' portfolios. But their fixed capital structure helps to reduce dealing costs.
Overall, investment trust charges generally tend to be lower. Moisson points to two factors that help to keep costs down. "TERs can be affected by fund size and with larger investment trusts the economies of scale tend to be passed on to investors.
However, the role of the board of directors on investment trusts is particularly important. They represent the interests of shareholders and have played a significant role in controlling costs."
However, a further consideration for investors are the discounts to net asset value that often exist on investment trusts, whereby trusts trade at prices below the actual value of their investments.
Discounts are not a cost as such, as they are a function of the supply and demand for a trust's shares.
Although discounts can reduce an investor's return if they widen after a trust is purchased, they can also be viewed as a buying opportunity. A narrowing discount can boost returns.
How the UK fund industry compares
International comparisons of TERs show that UK OEICs and unit trusts are among the most expensive globally, beaten only by offshore, cross-border funds sold out of Luxembourg or Dublin, which are also being increasingly sold in the UK through advisers.
According to Lipper FMI, the average TER for actively managed equity funds in the US is 1.32%; in Germany it is 1.57%; and in the UK it is 1.66%. European cross-border fund TERs average 1.98%.
And, while fees on US funds have been falling for the past four years, in Europe they are rising steadily.
In the US, there are fewer funds but they are larger which benefits investors because TERs tend to fall on funds as their size increases. This does not tend to happen in the UK.
However, in the US, there is the advantage that contributions to 401,000 retirement plans help to ensure a steady flow of business for fund managers which does not currently occur in the UK. Commission payments to advisers are also lower in the US.
The FSA's Retail Distribution Review, designed to shift the UK towards a fee-based advisory model, might help to bring fund charges down.
But investors will still need to be aware of how much they are being charged by the fund companies so the wool cannot be pulled over their eyes.
What fund companies say
Gordon Davidson, joint managing director, Jupiter Asset Management: "Investors probably don't understand charges very well. Key features documents do need to be made more user-friendly and IFAs also need to help investors understand fees better.
"On our latest fund launches we have reduced our fixed fee to 1.25% in exchange for the performance fees. We have not marketed them direct to the public because we believe it is for advisers to explain how they work."
Alex Hoctor-Duncan, head of retail sales, BlackRock: "A debate about performance fees needs to happen, but the way we see it a performance fee should be regarded as the cost of the outcome rather than the price of the product.
"Index trackers are cheaper, but during 2008 they fell in value, whereas our UK Alpha fund made money, so which type of fund is more expensive? And in 2009, we did not charge a performance fee because the fund did not reach its previous high water mark."
Jonathan Willcocks, managing director of global sales, M&G Investments: "Transaction charges are an integral part of investing in the stock market and if investors bought shares direct they would be exposed to the same charges paid by the funds.
"However, we are great believers in transparency which is why we publish our portfolio turnover rates. If the Investment Management Association and FSA could agree a standard formula for adding transaction costs to TERs we would support it."
For investors who want to keep their costs down, tracker funds and ETFs are clearly the least expensive option.
But for investors who want actively managed funds, assessing the cost of these investments is no easy matter and the increase in performance-related fees makes it even more problematic.
A spokesperson for the Financial Services Consumer Panel, which advises the Financial Services Authority (FSA) on consumer concerns, says it is a problem it is interested in looking into in more detail.
The FSA, however, is awaiting the outcome of an exercise being undertaken by the Committee of European Securities Regulators, which is in the process of revising current fund literature given to investors and replacing it with a new key features document.
An FSA spokesperson said the completion of this process is expected in July 2011. So it could be at least two years until any change is implemented.
In the meantime, fund managers must take the initiative and make the true cost of investment clear to investors. TERs must be given more prominence and performance fees better explained.
Portfolio turnover rates and transaction costs must also not be hidden under the carpet.
This article was originally published in Money Observer - Moneywise's sister publication - in March 2010
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
The practice of locating your financial affairs (banking, savings, investments) in a country other than the one you’re a citizen of, usually a low-tax jurisdiction. The appeal of offshore is it offers the potential for tax efficiency, the convenience of easy international access and a safe haven for your money. However, offshore is governed by complex, ever-changing rules (such as 2005’s European Union Savings Directive) and, as such, is the exclusive province of the wealthy and high-net-worth individuals.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
Key features document
The key features document (KFD) gives consumers the main points about any financial product or service they are considering purchasing without having to resort to the fine print. The KFD must include key headings outlining the product, its features, benefits, aims, risks and the requirements the consumer has to meet as well as a Q&A section. Although no two KFDs are exactly alike (each product requires a bespoke KFD), the FSA issues guidelines for how financial services companies should present the KFD to prospective customers.
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.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
Describes the relationship between a client and a stockbroker or independent financial adviser whereby the broker or adviser acts solely on the client’s instructions and doesn’t offer any advice on which shares to invest in or financial products to buy and simply “executes” the wishes of the client, regardless if they are judged to be sound or wrong. Other types of broking service offered are advisory (whereby the client/investor makes the final decisions, but the broker offers advice) and discretionary (whereby the broker manages the portfolio entirely and makes all the decisions on behalf of the client).
Not to be confused with an early repayment charge (ERC). Exit fees are levied on top of ERCs, which are a method of clawing back lost interest on a loan repaid early. By contrast, exit fees are charged for the administrative work this entails. They are charged as flat fees, from £150 to £300. However, in January 2007, following mortgage lenders surreptitiously raising fees sometimes by fivefold, the Financial Services Authority (FSA) intervened and most mortgage lenders removed exit fees from new mortgages. If you paid exit fees on your mortgage before January 2007, you may be able to claim them back.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
The Financial Services Authority is an independent non-governmental body, given a wide range of rule-making, investigatory and enforcement powers in order to meet its four statutory objectives: market confidence (maintaining confidence in the UK financial system), financial stability, consumer protection and the reduction of financial crime. The FSA receives no government funding and is funded entirely by the firms it regulates, but is accountable to the Treasury and, ultimately, parliament.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.