Are you being ripped-off by fund charges?
We are used to analysing a fund manager's track record or a fund's performance history before deciding where to invest our money, but it's important not to underestimate the dramatic impact that fund charges have on your portfolio's performance too.
Fund management groups levy a dizzying array of one-off and ongoing costs that can wipe thousands of pounds off the value of your investments, according to Justin Modray, a former IFA and founder of financial website, candidmoney.com.
He gives the example of £10,000 in a unit trust with 5% initial and 1.6% annual charges. Assuming a 6% annual return, this investment would be worth around £14,613 after 10 years – a staggering £3,296 less than if no charges had been applied.
"Fees and charges can really hinder performance," Modray says. "While low charges are no guarantee of success, they're well worth seeking out, provided you don't compromise the quality of fund management or the index being tracked."
But finding out how much a fund will cost can be a challenge. The types of fees vary not only between different investment vehicles, but also among funds that have the same overall objectives. Different charges will also apply at different times.
So what are all these fees and how will they affect the value of your holdings? We have divided them into four main categories: one-off charges; annual operating costs; performance-related fees; and activity-related expenses.
1. ONE-OFF CHARGES
These are charges that will be levied only once; some will be due when the product is first purchased, while others will be payable at key points during the life of the investment.
An initial charge is paid when an investor buys units in a fund. It helps cover the marketing and administration costs incurred by the investment house, as well as any commission that has been earned by the financial adviser.
The typical initial charge for an actively managed fund – as opposed to an index-tracking product – is 5%, of which 3% will usually go to the adviser as part of their commission. However, the amounts charged can vary between providers.
For example, fund groups often run special campaigns during which time the initial fees are reduced or, in some cases, waived completely. In other cases, a financial adviser will charge a fee for advice given rather than receiving commission.
Basically, if you invest £1,000 in a fund which has an initial charge of 5%, then £50 will immediately go to the investment house and only the remaining £950 will be invested on your behalf.
If you decide to switch your money into a fund run by a different manager this will result in new initial and annual management fees. Moving between funds run by the same manager, however, should be cheaper – or even free.
So if you intend to switch regularly, then it will probably make more sense to invest via a fund supermarket.
This relates to unit trusts. There are two prices quoted for some funds: a price to buy (the 'offer price') and a price to sell (the 'bid price').
The latter is always lower than the former and the bid-offer spread is the difference between these two prices, expressed as a percentage.
From an investor's point of view, the spread is an extra cost, just like the broker's commission or any other charge.
Although rare, some funds won't levy initial fees on your investment but will wait until units of the fund are sold and then charge. The idea is to encourage people to keep their money invested for the longer term – which is why exit fees usually decrease over time.
For example, the fee could be a 6% charge in year one, 5% in year two, and no charge at all from year seven onwards.
2. ANNUAL OPERATING COSTS
These are the ongoing costs incurred by the fund to pay for its management. As these costs are borne by the fund, they will have an indirect impact on your investment through reduced fund performance.
Annual Management Charge
The AMC covers the basic ongoing costs of running a fund and varies between 0.2% and 2% of its value. However, this is not a comprehensive figure because extra charges such as administration are not included.
Also, multi-manager funds, which are products that invest in other funds, will quote their own annual charges, on top of which additional fees will be added to cover the cost of holding underlying funds.
A fund will also rack up a raft of other charges, including fees paid to accountants for auditing and custodians for looking after the money, and you will pay a share of these.
Total Expense Ratio
This is not a different charge to those already listed but simply an amalgamation of the ongoing annual fees. In other words, it's a combination of the annual management fee and the costs of custody, administration and auditing.
The idea behind the 'total expense ratio' (TER) is to give investors an idea of the running costs associated with investing in a particular fund. It's therefore more important to look at a fund's TER than its AMC. It doesn't, however, include dealing costs and trading commissions.
3. PERFORMANCE-RELATED FEES
This is an annual cost that some fund groups charge, which is dependent on the manager's performance. It can be included in the TER, but it's worth double-checking to make sure that this is the case.
These fees can vary enormously. Some will charge 10% for hitting pre-agreed targets, while others may demand as much as 20% of any profits.
In addition, fund groups will normally always charge annual management fees and won't be under any obligation to lower them just because they are levying performance fees as well.
Ed Moisson, Lipper's director of fiduciary operations, Europe, says: "If you invest in a fund with a performance fee, make sure you understand how it works.
Is the benchmark appropriate? For example, be very cautious about investing in an equity fund that earns performance fees for outperforming a cash rate."
4. ACTIVITY-RELATED EXPENSES
The final section includes general costs not covered by the AMC or the TER.
These are costs incurred by the fund when the manager buys and sells shares. Modray explains: "They are something of a black hole because they don't need to be disclosed in the TER, although they will obviously be reflected by overall performance."
This information will be partly detailed in the fund's accounts but can be difficult to understand. The effect they will have on your investment will depend on how many changes the manager has made – this is known as the 'portfolio turnover'.
A turnover rate of 25% indicates a fund holds its portfolio for a period of four years, 50% for two years, 100% for a year and 200% for six months.
Lipper estimates that a fund with a portfolio turnover of 100% during the course of a year would be expected to incur trading costs of approximately 1%.
Depending on the investment, stamp duty may also be payable by the fund group as part of its dealing.
Q: How do charges affect my investment?
The odd 1% here and there may not sound very much but you have to remember that these fees will apply for as long as you hold the investment – which means the overall amount paid out can end up being fairly substantial.
Take the example of £1,000 invested in a fund with an initial charge of 5% that is earning returns of 7% a year before charges. If it then charges annual fees of 0.5%, the value of the original investment would be worth £1,783 after 10 years.
If the annual charges were 2.5%, then this total would shrink to £1,475 – a fall of £308, according to Lipper.
However, look at the same scenario if the initial charge is waived: the value of £1,000 after annual fees of 0.5% are deducted would be £1,877 after 10 years, and £1,553 if the charge was 2.5%.
So the higher-charging fund will have effectively eaten away a further 20% of your investment.
Q: What should I pay?
It might sound strange but there are circumstances when it makes sense to pay an apparently high fee, as Andy Gadd, head of research at Lighthouse Group, points out. The key is to know when to do so, and when to opt for the cheapest product on the shelf.
You should never pay more than 0.5% for a tracker fund, for example, whose purpose is to closely mirror a given index, as the amount of day-to-day work required is minimal compared with actively managed portfolios.
As trackers don't regularly trade shares they have lower fees – sometimes lower than 0.3% – whereas active funds often levy 5% initially, then 1.5% annually, because the fund manager may be spending more time dealing in shares.
"It's well known that minimising costs is one of the keys to achieving superior investment returns, but if you want access to superior investment talent then that's a skill that has to be paid for – it doesn't come free," adds Gadd.
Just remember, though, that a high TER is no guarantee of consistent double-digit returns.
Q: Are fees getting more expensive?
Research by Lipper shows the average management fees of actively managed equity funds have risen from 1.33% in 1998 to 1.49% today. The average TER, meanwhile, has gone up from 1.52% to 1.66% over the same period.
It's little wonder, then, that some seasoned observers have started to question how fair the industry is being to consumers, and whether a thorough root-and-branch overhaul of the entire fee structure is long overdue.
Alan Miller, the former chief investment officer of New Star and now co-founder of Spencer-Churchill Miller Private, has been among the most vocal critics of fund fee structures and has launched a withering attack on what he believes are hidden charges.
He claims a combination of dealing commissions, taxes, market-making spreads and entry/exit commissions could be costing investors an extra £5.8 billion collectively in charges that are not already covered by TERs.
"These hidden charges act as a significant drag on performance, particularly when overall returns are low," he adds. "It's time for a new calculation to be adopted that includes annual management fees and all the other charges impacting overall returns."
This accusation has angered fund management groups, and prompted Richard Saunders, chief executive of the Investment Management Association, to come out fighting on behalf of the industry.
"Investing certainly isn't cost-free, but examination of the facts shows that both active and passive fund managers have a good story to tell," he says.
Q: How can I cut the cost?
Whatever the reality, the good news is that you can reduce the cost of investment by going through a fund supermarket or discount broker – such as Hargreaves Lansdown, Chelsea Financial Services or Interactive Investor.
These can offer substantial discounts because they are able to negotiate special deals with product providers.
In many cases, supermarkets or discount brokers will waive the initial charges, and may even offer cheaper AMCs.
However, the downside is that you won't have the same sort of access to financial advice – although many such firms publish research in financial magazines and on websites.
|Four signs you are paying too much|
|You are paying a high annual management charge, but you've bought into an index tracking fund|
|The performance targets have been set too low|
|Your fund manager is trading excessively, but performance is still poor|
|You have bought direct from a fund management house – this is the least cost-effective option|
For more information on fund charges, head to the website of our sister publication, Money Observer, which has been running a campaign to unveil them since February.
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.
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).
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.
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.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
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.
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.
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%.
Investment funds that invest in other investment funds from a wide range of asset managers and are often referred to as funds of funds. Some multi-manager funds only invest in the funds of the investment house providing the fund of funds and these are known as “fettered”. An “unfettered” multi-manager fund is free to invest in what the fund manager believes are the top performing funds from across different markets and industries. Investing in multi-manager funds means your risks are spread across geographical regions and industry sectors but it also adds another layer of charges and some multi-managers also levy an out-performance fee.