How to cut the costs of investing
Fees vary enormously and can have a dramatic impact on your profit. After all, there's little point in buying a fund that delivers a bumper double-digit return if you end up paying most of it back in charges, says Jason Witcombe, spokesperson for Evolve Financial Planning.
"If one fund charges 0.5% a year and another charges 1.5%, the more expensive fund will have to produce an extra 1% just to keep pace," he explains. "That's a big ask in the current environment and most of the higher-cost funds won't be able to achieve this."
These differences might not sound much but the impact can be vast when measured over time, due to what is known as the cumulative 'drag' effect.
For example, an £11,280 fund investment - the current annual limit for ISAs, growing by 7% each year - will reach £22,190 after 10 years before costs are added into the equation. However, annual charges of 1.65% would reduce this to £19,000, whereas fees of 2.5% would shrink it to £17,520, according to data from Lipper.
Meanwhile, some low-cost index-tracking funds have annual charges of 0.3%, which would reduce the same investment over 10 years to a healthier £21,575.
Fees and charges
The problem with fees and charges is that they aren't particularly transparent. What charges apply and how much they are going to set you back can vary enormously and the whole process isn't always clear, according to Geoff Penrice, an independent financia; adviser with Honister Partners.
"There is the annual management charge (AMC) and then other costs, which, when added to the AMC, will be expressed as the total expense ratio (TER)," he says. "However, this isn't the full picture as there will be dealing charges on top of the TER."
By far and large it seems the industry likes to keep it this way - after all, the confusion helps to boost its pockets. Don't let this trick you. The second lesson of Moneywise's Investment School will guide you through the maze.
The good news is there are plenty of ways to reduce your expenses, in terms of the products available and how you go about buying and selling them.
The most obvious way to reduce your costs is by opting for passive rather than active funds. These products are often referred to as trackers because they attempt to replicate an index, such as the FTSE 100, rather than beat it. As you are not paying a fund manager to make decisions, the annual costs will be lower at around 0.5%, rather than 1.5%.
Opting for a passive strategy doesn't automatically mean you will miss out on performance. Given that so many active managers underperform, it could be a wise move, says Penrice. It all comes down to individual funds.
"It's unfair to assume lower-charging funds will outperform more expensive funds because a well run higher-charging fund may give much better returns than a poorly run cheaper fund," he says.
"In fact, with strong-performing funds, the level of charges becomes relatively unimportant."
It's impossible to say whether active or passive strategies are better, points out Justin Modray, founder of website Candid Money. "Hedging your bets by combining both in your overall portfolio makes sense."
You may also want to consider exchange traded funds (ETFs), which have grown in popularity over the past decade. These provide access to a wide range of different investments, including exposure to various countries and asset classes, at relatively low cost.
Their passive approach makes them similar to tracker funds but the difference is that they are traded on an exchange similar to a share. This gives investors relatively straightforward access to a wide variety of investments on a real-time basis.
Although ETF transactions are subject to the same fees as share transactions, they generally have lower management fees. They can also be traded at any time, offering investors much greater control in terms of timing.
It is also worth looking at investment trusts, suggests Andy Merricks, head of investments at Skerritt Consultants. "Some unit trusts have a mirror investment trust, which will almost always be cheaper," he says.
Investment trusts are quoted companies in which you buy shares, the price of which will be determined by supply and demand rather than the value of the underlying assets, meaning their value can fluctuate more than unit trusts, although fees are usually lower.
Trusts can also retain up to 15% of the income they receive each year and put it into their reserves. This process, known as 'smoothing', helps them pay dividends in more difficult years and is worth bearing in mind.
There are also other ways to cut costs. Using a fund supermarket could be a good idea. This enables you to hold your funds on a single trading platform, which can make it far easier and cheaper to keep track of your investments, says Patrick Connolly, spokesperson for AWD Chase de Vere.
"They allow investors to select from a wide range of funds, and you may get a cheaper deal when investing through one."
Finally, don't forget to shield as much money as possible away from the taxman - the first port of call should be utilising the tax-efficient qualities of your annual ISA allowance.
Investment trust: Edinburgh Investment Trust
Fund manager: Neil Woodford
Dennis Hall, financial planner for Yellowtail Financial Planning, says: "I like this trust as it has a good manager at the helm who is prepared to take a position and hold it."
ETF: iShares FTSE Gilts UK 0-5 years ETF
Jason Witcombe, spokesperson for Evolve Financial Planning, says: "This is worth a look. It is physically backed and has an annual total expense ratio of 0.2%. It is also short-dated so shouldn't be as volatile as longer-dated bond funds."
Tracker: HSBC FTSE 100 Index
Patrick Connolly, spokesperson for AWD Chase de Vere, says: "It is notoriously difficult for active fund managers investing in large-cap UK shares to outperform the index. This tracker fund gives exposure to FTSE 100 companies with an annual charge of just 0.25%."
Tracker: L&G Global Emerging Markets Index
Andy Gadd, spokesperson for Lighthouse Group, says: "For those prepared to take a higher risk over a longer time, economic growth in emerging markets is still strong. The objective of this fund is to provide growth by tracking the FTSE All-Share World Emerging Index."
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.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
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).
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%.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
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%.