Different types of investment Are fund charges eating into your returns?
If you’re an investor with investment funds like unit trusts and open-ended investment companies (OEIC), your primary concern will probably be about how the current stock market volatility is affecting your investment and the returns you’re receiving.
However, share prices aren’t all you should be worrying about - the charges you have to pay with investment funds can have an equally devastating effect on your returns.
Fund managers have been gradually increasing the amounts they charge for running actively managed funds over the past decade, and this can really eat away at your investment.
Even if your investments are earning 7% a year, that will be of little use if you’re paying a chunk back to the company simply for the privilege of being invested in their fund. So what are these charges – and how can you make sure that you’re getting value for money?
What investment fund charges will you face?
There are two main charges you will encounter when you buy unit trusts and OEICs – an initial fee and an annual fee.
This is levied as a set up cost for investing in the fund.
In an OEIC, the initial fee is simply levied as a percentage of your overall investment, typically around 5%. So, if you were to invest £10,000 in a fund, you would actually only be investing £9,500 after the initial fee.
If you were investing on a monthly basis, the initial fee would not be deducted from your investment but instead be reflected in the cost of the shares you were buying. So each month that you invested, the cost of the shares would actually be 5% higher than the quoted price.
In a unit trust, the initial fee is usually calculated by difference the initial fee is usually the difference between the offer price (the higher, buying price of the units) and the bid price (the lower, selling price) on the day of purchase. This difference, known as the spread, is the start up cost you will pay. Spreads are usually 5% but can be as high as 7% or 8%.
Annual management charge
These pay for the ongoing annual costs of running the fund. The annual management charge (AMC) is typically made up of a number of different costs, and averages to around 1.5% in most unit trusts and OEICs.
This differs from fund to fund but, generally, the funds that invest in riskier assets, like equities and property, will have higher AMCs than their lower risk counterparts, like corporate bonds and gilts. But the AMC is not necessarily representative of what you pay on a yearly basis.
What is the total expense ratio or ongoing charge?
A more realistic indication of the true annual cost is a measure called the ongoing charge or total expense ratio (TER). This includes the AMC, as well as a number of additional costs such as trustee and auditor fees, which are taken directly out of the fund.
Fund managers are legally obliged to show the ongoing charge in their fund literature and they must publish it once a year. It can be found in a document called the Key Investor Information Document (KIID).
Other costs of investment funds
While for the time being the ongoing charge is a good indicator of annual charges, it’s, unfortunately, not the whole picture. The transactions that fund managers undertake within their funds – the buying and selling of different assets – all incur costs, like trading fees, commissions and stamp duty tax (on UK shares).
Regulators carried out a study into this in 2005, and found that an annual turnover rate of 100% (all assets in the portfolio had been bought and sold in one year) would cost you an extra 1.8%. Add that to the average ongoing of 1.67% and you're looking at annual costs of over 3%. Of course, the trades taken by the fund could boost your returns by even more and a good manager wouldn't spend money on the trades without thinking it would enhance performance.
Some funds charge exit fees, usually if there has been no initial charge fees. These reduce the longer you hold the investment fund, and usually disappear after five to seven years of investment.
A growing trend in unit trusts and OEICs, and commonplace in investment trusts, is the levy of performance fees on top of the regular annual charges – typically taking an extra 20% of everything above a certain level of performance.
The argument for this is that they align the interests of the manager with that of the investor but it’s important you check to see if there's a performance fee levied and that you fully understand when it’s triggered before you invest.
The impact of charges and how to cut them
The threat posed to your returns through high charges can be very dramatic. Research from Which? shows that if you invested £10,000 in a fund with no charges, and it grew by 6% annually for 20 years, you’d get a return of £32,071 – just over £22,000 growth.
If you invested in a fund with the industry average ongoing charge of 1.67%, your return would be reduced to £23,344 – meaning £9,000 of your growth goes on charges. If the TER was 2.5%, £12,000 would be paid out in charges. That’s not even factoring other costs, such as transaction costs.
Fortunately, there are ways for you to cut costs. Tracker funds and ETFs are much cheaper in comparison to actively managed unit trusts and OEICs, typically charging between 0.2% to 1% per annum. They also don’t have transaction costs as they are just buying the assets within an index.
Investment trusts can be riskier, though, so if you do decide on a unit trust, you can get significant reductions in costs by investing through a fund supermarket or discount broker. By doing this, you can usually reduce 100% of the initial fee and sometimes a significant part of the AMC, and this can bring about a significant boost to your savings as illustrated in the graph below.The downside is that most of these discount brokers work on an execution only basis (meaning all decisions are made by you without advice). If you’re unsure about investing, you should seek independent financial advice before you go ahead, and only those confident and knowledgeable about investment markets should go it alone.