Ensure fund fees don't eat your profits

When you are deciding where to invest your hard-earned cash, it makes perfect sense to analyse an investment fund's objectives and the past record of its manager. But it's just as important not to overlook another key factor: the charges.

The fees levied by fund houses on products such as investment trusts, unit trusts and open-ended investment companies (OEICs) can dramatically affect your returns. A portfolio may well be delivering 20% a year, but that's little use if you're paying most of it back simply for the privilege of being invested.

As these charges can wipe thousands of pounds off a typical investment's value, you need to know how much a particular investment product will cost over the longer term. "It's vital that fund managers more than compensate for the fees by beating the index, otherwise investors are better off buying low-cost trackers," says Justin Modray, communications manager at IFA Bestinvest. "Good managers can justify their charges - but they tend to be in the minority."

So what are you actually paying for? Well, the charges help cover a multitude of expenses incurred by the fund management group, including the cost of buying and selling of shares for the fund, the managers' salary packages and administration costs.

Charges also come in different guises: for some products you will pay an initial fee and then an annual management charge; others have exit fees (due when fund units are sold) instead of an initial charge; while a growing number are performance-related.

To add to this confusion, there are times when it makes sense to pay a hefty charge and others when there's no point at all. Knowing the difference is one of the keys to enjoying decent returns over the longer term.

The best starting point is to gain a thorough understanding of the different costs you are likely to come across. In most cases, these will be the initial fees and annual management charges.

Initial charges

An initial charge is paid when an investor first buys into a fund. It helps pay for the marketing and administration costs incurred by the investment house, as well as any commission that has been earned by the financial adviser. The average 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.

But the amounts charged are not always set in stone. For example, fund groups often run special campaigns, during which time the initial fees are lowered or - in some cases - waived completely. In other cases, a financial adviser will charge a flat fee for advice rather than demand a commission.

Annual charges

These fees are levied to cover the ongoing costs of running and administering a fund and, on average, will cost between 0.75% and 1.5% of the fund's value.

The odd 1% here and there may not sound much, but these fees will apply for as long as you hold the investment, which means the overall amount paid out in charges can end up being substantial.

Exit fees

Some funds won't levy initial fees on your investment, but will wait until units of the fund are sold and then charge. Obviously, you should look at how this will work in practice and compare it with funds working the other way around to see which is likely to be the most cost-efficient for your needs,

It's worth bearing in mind that the idea here is to encourage people to keep their money invested for the longer term, which is why exit fees usually decrease - say, from 5% to nothing over a five-year period.

Other costs

Unfortunately, this isn't where the charges story ends. As well as initial, annual and - in some cases - exit fees, a number of other potential charges apply to certain products. In recent years, there has been a move towards performance-related fees. While this can appear to make good sense, you have to take a detailed look at what's being offered to ensure it actually makes sense over the long term.

Research by Lipper Fitzrovia on fund performance fees found that 10% of equity funds examined were set up in such a way that investors can be charged performance fees if the fund outperforms a falling index - even when suffering negative returns. That means you still have to pay up even if the manager has lost you money.

Multi-manager funds

These products can cost you more because you have to pay fees relating to the underlying holdings of the portfolio as well. This is often referred to as the 'double charge'.

The hope with these funds is that - by gaining access to a wider range of fund management talent - the extra costs will be offset by a substantial boost to performance.

What should you pay?

If it's an index-tracking product, which is constructed on the basis of what companies are in the specific index it is following, then you should definitely not pay much in the way of fees. The only type of funds where higher charges are more acceptable is in actively managed funds, but some are worth the money while others are not.

Shopping around

Once you know how the different charging systems work, you can concentrate on getting the best possible deals. The good news is there are many ways to avoid charges without reducing your choices or taking any additional risk. You should start by researching providers offering discounted charges - there are many online brokers and fund supermarkets offering such services.

Even if you choose to pay extra for the advice of an adviser, rather than using a discount broker, it's still worth pushing for lower charges. While it clearly pays to keep a close eye on fees, you should never let them rule your investment decision - factors such as portfolio balance and the quality of fund management can be equally as important.

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