Don't get ripped off when buying funds

For an explanation of common fees, read: Four fees and charges you should watch for before buying funds.

Money never sleeps, suggests the sequel to the movie Wall Street, but investors will need to pop a few ProPlus tablets if they want to prevent too much of their cash sleepwalking into the pin-striped pockets of greedy fund managers in the form of fees.

Private investors are frequently dismayed when they discover just how much of their hard-earned cash is gobbled up in fees each year, even by poorly performing fund managers.

Karen Ritchie, financial planning director of independent financial adviser Financial Planning for Women, says: "Investment managers and wealth managers claim to work hard actively managing your money on a daily basis, to make you more money.

"But beware: many cream off so much in initial fees, annual management charges (AMC), dealing commissions and even commission from other fund managers that your money has to work twice as hard to keep up with the rest of the market."

Simon James, partner of discretionary investment manager Gore Browne, agrees that fees sometimes devour more of an individual's savings than they realise.

"If investors want a return of 7% a year, they have to put their money into riskier assets than cash or gilts, and that's going to cost more. You're looking at 20% to 30% of their gains being eaten up by fees," he says.
A survey by The Daily Telegraph in 2010 calculated that each year an eye-watering £7.3 billion is paid by investors in fund management fees.
One problem is that small investors often focus only on the AMC (typically 1.5%), which they believe is the only cost. But less obvious in most product documentation is the total expense ratio (TER), which is a truer reflection of how additional charges dent investment returns.
Another snag is that investors often don't pay enough attention to the price tag when they choose a fund, as Patrick Connolly, spokesperson for independent financial adviser AWD Chase de Vere, points out.
"Too often investors just look at the top of the performance tables," he says. "A fund may only have got there by taking a big risk; it pulled that off, but then doesn't go on to show consistent performance. Many people then find they are stuck paying the charges on a mediocre fund."

John and Sheila Shipway had their eyes opened to the shocking impact of charges after seeking independent advice on the range of personal equity plans (PEPs) and individual savings accounts they had taken out with leading fund managers in the late 1990s and early noughties.
John, 76, a retired catering business owner from Birmingham, says: "I was horrified to find out that we were paying £480 a year on just the AMCs on our investments. I had bought the funds direct and hadn't been made aware of all the other costs. I was old-fashioned and trusted the fund managers - just as I used to trust the bank manager.

"Perhaps I should have been more on the ball. My adviser showed me that management charges of 1.5% a year were just the start. This excluded trading costs which could add another 1.5% to 2% a year."

The couple invested in a portfolio of low-cost passive funds from Vanguard and Dimensional, with average fund management charges between 0.15% and 0.40%, totalling just £128 a year. John says: "I am happy with the deal we now have. I would recommend others to get out a magnifying glass and read the small print."

Passive funds

Passive funds such as trackers and exchange traded funds are a popular choice for those who are unwilling to either keep an eye on asset allocation or pay high charges.

The funds invest in shares to reflect the make-up of a particular index, such as the FTSE 100 or FTSE All Share, so management charges are lower to mirror the fact that there's no stockpicking involved.
According to Ed Moisson, head of UK research at fund analyst Lipper, a typical UK tracker fund should charge no more than 0.5% a year, but there are some that apply double that amount. Among the cheapest are HSBC's range of UK trackers charging just 0.27% a year, while Virgin's UK Index Tracker at 1% is one of the priciest.

But even a low charge can be a nice little earner for managers and have a high impact on returns. Moisson says:  "People are not always aware of the 'drag' effect of charges over the longer term: 0.5% may not seem much to a retail investor with £10,000, but they probably have little awareness that it means £2.5 million each year for the manager of a £500 million fund."
Some types of investment have a more damaging impact on the returns of unsuspecting investors than others. Examples include 'funds of funds', whose charges can be hard for buyers to calculate, and absolute return funds which may also apply performance fees.

For more on passive funds read: Exchange traded funds vs passive mutual funds

Funds of funds' inflated fees

Connolly says: "Investors would be shocked if they realised just how much they're paying for funds of funds. All you see is what the company you're buying from is charging, but you also pay charges on the underlying funds, typically bringing the total cost to as much as 3% a year."
However, the TERs on funds of funds vary widely, with Henderson Multi-Manager Active charging 3.24%, compared with HSBC Income fund of funds at 1.94%, for example. Someone investing their £10,200 ISA allowance, assuming 7% growth a year, would see it grow to £13,331 after five years in an active fund charging 1.5% TER, while a fund of funds investment at 2.5% TER would grow to just £12,711.

When stockmarkets are booming and investors see their returns rising, then the impact of such charges is less noticeable. When markets are erratic, however, as they are now, the effects are like the steam suddenly disappearing from a Turkish bath. Connolly says: "The naked truth is revealed and investors begin to question whether poor performance deserves the inflated fees."

Moisson says that TERs actually tend to rise when markets get tougher and fund assets fall, as managers try to maintain profitability.

So are investors being ripped off? Connolly says: "In some cases, yes; in others, no. It's important to point out that cheapest isn't necessarily best, although the funds with higher charges need to perform well just to remain on an even keel."

What should you do?

Investors stuck in high-charging funds need to be pragmatic, advises Ritchie. "By moving they could incur further charges and possibly face tax implications, so they need to ask what the effect of moving elsewhere or encashing would be," she says.

"Above all, don't 'cut your nose off to spite your face' and be realistic about the charges. If you're happy overall with the service and performance, stick with it - at the end of the day, good service does not come for free."

Read:Tips for picking the perfect funds

However, the howls of opposition to stubbornly high charges have been growing louder recently as the Retail Distribution Review of 2012 approaches, when adviser trail commission will be removed and the true cost of investments become more transparent.

In the original Wall Street, the anti-hero Gordon Gekko was famed for his scathing reproach that "lunch is for wimps". Investors should take care that their fund managers aren't dining too heartily on your investment returns.

Are performance fees necessary?

NO says Philippa Gee, managing director of Philippa Gee Wealth Management, is one of the many IFAs who oppose performance fees.

"They are absolutely not necessary and I'd say that those who charge them are greedy," she says. "The annual management charge should be enough. The fund manager's job is to manage the fund to the best of their ability; if the fund does well and grows, then the amount they receive is more anyway. Investors don't like these charges and they're paying enough already.
"It's also laughable how low some managers set their benchmarks - often just the Bank of England interest rate which is currently at 0.5% or, even less challenging, the three-month LIBOR rate (the rate at which banks lend to each other), which is currently 0.29%."

YES says Fund manager J O Hambro has applied performance fees to all its open-ended funds since its launch in 2001 in order to attract high-calibre managers who might otherwise choose to run hedge funds. This extra fee is 15% on returns in excess of a benchmark.
Suzy Neubert, director of sales and marketing at J O Hambro, says: "We strongly believe that performance fees are a highly effective way of aligning the interests of our fund managers with those of our clients. All companies say that they put their clients' interests first, but not all really do.

"Linking the revenues of fund managers to their ability to add value for their customers via performance-related fee structures ensures fund managers have a greater incentive to deliver sustained outperformance. Crucially, we apply a high benchmark so that any fund underperformance is carried forward and no fee is payable until the performance has recovered."

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