How fund investors can pay a third less for the same fund

Calculating savings

My mum used to run a catering business, and I have very happy memories of sitting on vast trolleys in the cash and carry clutching massive sweet shop-sized tubs of sweets.

However, historical quirks mean the investment industry isn't so sweet; indeed, buying direct can be the priciest option.

An estimated £20 billion is invested directly with fund managers, but the charges on those investments are likely to be higher than loyal long-term customers would typically pay for the same thing anywhere else. If you hold funds directly with a fund manager, it may be time to think again and - counter-intuitively - find yourself a middleman.

 

Retail fund costs

It is worth recapping on how the industry has progressed. Before the regulatory changes implemented earlier this year, investors paid for funds in one fell swoop each year.

Everything was bundled together: adviser, administration and investment manager costs. They were all aggregated into one annual charge and paid for by customers in an opaque, blurry way.

We might assume pricing models in the investment industry to be marvellously complicated and honed into a rigorous science, but actually it is back-of-a-fag packet stuff. A few industry bigwigs decided that 1.5% of a retail investor's portfolio was a ‘fair price' to charge, and so it came to pass.

That included the costs of those making the investment decisions (fund managers), plus payments to the administration people (brokers, platform managers or fund managers again) and any advisers involved.

Sheep-like, fund managers charged retail investors 1.5%, regardless of how good they were, the services they offered or their true cost base. Voilà.

The problem for the DIY investors out there was that this 1.5% included a 0.25% commission for advice. If you didn't actually receive any advice, too bad, you paid for it anyway, and the fund manager got to keep it.

Similarly, if you didn't use a platform or broker, the fund manager kept the chunk the middleman would ordinarily have received too.

Yes, the manager administered the fund, so a portion of the fee was deserved. But typically, the administration was carried out appallingly badly on abysmal systems, so it was like flying on Lao Airlines but paying for Virgin Galactic.

Pre-retail distribution review charges

0.75% fund manager + 0.50% broker + 0.25% adviser = 1.5% cost of investing

Charging practices changed under the so-called Retail Distribution Review in 2013. This forced fund management groups, advisers and platforms to 'unbundle' their charges, so that investors knew what they were paying to whom.

To many people's confusion, platforms and advisers were forced to convert everyone into 'clean' (unbundled) share classes by April of this year.

A handful of 'transparency Persil Automatic' was added to the mix: investors were charged a specific fee for the fund manager, and a specific separate fee for the platform/broker.

So instead of paying 1.5% that included a built-in fee for advice and administration, investors now typically pay an average 0.75% to the investment manager and a lower administration fee to the platform or middleman, which averages out at about 0.4%, depending on where you hold your account.

 

Typical charging structure today

0.75% fund manager + 0.40% average platform fee = 1.15% cost of investing

So far, so good - if you are using a platform. Lots of people are now paying less for their investments than they were.

Forget factory gate pricing

However, one group has escaped the requirement to shift customers to clean share classes: fund management groups. Anyone who bought direct from a fund manager in the past - and is typically paying a fee of 1.5% - has not been automatically converted.

So most investors who are invested directly with fund managers are worse off, and still putting up with a woeful administration service.

We looked at the associated fees on eight top-selling funds for DIY investors and compared the cost of going direct with the cost of buying through a third-party broker such as Hargreaves Lansdown or Fidelity.

In almost every case, it is cheaper to go through a third party (and my experience is that the service is always better too). The exception, Fundsmith Equity, is actively promoted on its website via a T class specifically for direct investors.

Many fund managers are actively engaged in building better services for direct customers, although the economic truth is that intermediaries such as trustees, pension funds and independent financial advisers still account for more than 95% of business by value, so guess where the development budgets go?

That said, even stuffy old finance is not immune to the digital revolution and direct access: some of the bigger managers are slowly modernising.

Charges matter

Over the long term, a 0.75-1% drag on an investment can matter, particularly when returns from stock and bond markets are low. These fees can nibble away at invested capital like termites.

As economists are fond of reminding us, we are in a lower-growth world, where economic growth is being held back by high levels of government debt. A 10-year UK government bond pays less than 1%.

The average income available from an investment-grade corporate bond fund is just 2-3%. The stock market currently pays dividend income of just under 4 per cent. In this context, a 1% additional charge is significant.

The longer-term impact on returns is worse. Someone investing £200 every month for 20 years and earning 5% cent can expect a pot of around £82,200 at the end of the period.

If the return is reduced to 4% by a higher annual fee, they will receive just £73,350 at the end of the term - a £9,000 hole.

Some fund groups have striven to address the problem, particularly the largest and most conspicuous ones.

M&G has launched a new direct platform that lowers the annual management fee and scraps initial charges for direct investors, making it cheaper in most cases to invest with the group than through an intermediary such as a platform or independent financial adviser.

However, other groups with large back-books of direct investors, such as Invesco Perpetual, have yet to follow suit.

 

What should you do?

First, check how much you are paying in charges. If you have direct holdings with a fund management group, they may be in old share classes. This should be obvious from the level of the annual charge, which will be stated on any correspondence from the group.

In general, if you are paying north of 1%, you will probably be in an old share class, and you should consider switching. Note that you should switch, rather than simply sell out and buy back in a new form, as selling may trigger capital gains and/or the loss of an Isa allowance.

Think about using a platform, which will be a bit like moving your account from a single-brand shop to a department store. It will be cheaper and probably easier to manage, because you can hold all your investments in one place and get one consolidated tax statement at the end of the year.

Even if you pay a visible fee of as much as 0.4% - which you will see disappear from your account - nine times out of 10 you'll be paying less for the service than you would if you went direct to a fund manager.

Don't be afraid to phone your fund manager up and ask them outright how much you are paying every year overall. If it's more than about 1.3%, I suggest you move.

Regulatory change will often cause anomalies, so fund managers are not necessarily being difficult.

It is administratively complex to switch lots of relatively small unit holders into new share classes. However, investors can always do the work instead. Don't assume that loyalty to your fund manager pays.

This story was originally written for our sister magazine, Money Observer.

Published: 10 November 2016
Last updated: 10 November 2016

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