If ever there was a time to clarify the true cost of investing, it is now. When markets are rising strongly, private investors don’t care much about whether a fund manager is overcharging for services rendered or that a performance fee is being levied for outperforming a benchmark index.

But the gut-wrenching downward lurch in global equity indices that we have seen in a very short time – including a 20 per cent fall in the space of a month for the UK’s FTSE 100 index – puts the spotlight firmly back on the cost of investing, particularly in actively managed funds. 

It’s been more than a year since Money Observer published a series of campaigning articles designed to highlight the costs of investing in everything from funds and investment trusts to pensions and Isas. Our aim was to highlight the pernicious effect of charges on long-term investment performance and lifestyle goals by forensically examining myriad investment costs. We also hoped to galvanise the financial services industry at large to meaningfully address failings in the services it provides.

When we totted up all the costs, our conservative estimate was that someone who invests directly in actively managed funds pays at least 3 per cent a year. This rises to 5 per cent or more for an investor who pays for financial advice, largely through the deduction of initial and ongoing commission payments. 

Money Observer has also highlighted research from Lipper, the fund performance specialists, that shows UK private investors pay the highest fees in the developed world for actively managed funds. That is one of the reasons long-term performance has been so underwhelming. Equally as important, of course, is the fact that the consistently high fees you pay are not matched by consistent long-term outperformance of benchmark indices. 

A research paper from iShares, the provider of exchange traded funds, reveals this inconsistency. Over a decade, just 36 per cent of equity funds and 31 per cent of bond funds that beat their benchmarks in one year achieved the feat in the following year. The chances of consistently doing that for the next two years was just 6.3 per cent for equity fund managers and 4.9 per cent for bond fund managers.

That’s why costs matter: they are a far better indication of future returns than past performance. In August 2010, extensive research by Morningstar in the US concluded: ‘Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on the funds in the cheapest two quintiles (top two-fifths) and you’ll be on the path to success.’ 

That’s all well and good for US investors, who enjoy far lower fund charges than UK investors, and where performance fees, when levied, work both ways, because they can be clawed back in periods of underperformance. In the UK annual total expense ratios (TERs) have increased over the decade, from 1.52 per cent in 2000 to 1.7 per cent in 2010, despite the fact that assets under management (AUM) in open-ended funds have soared from £250 billion to £600 billion. 

Perhaps all that extra cost to investors can be attributed to the sheer waste of effort on the industry’s behalf. At the end of 2009, 2,524 retail funds were available, compared with 2,437 in 1999. What is truly shocking, as the table to the left reveals, is that 2,507 new funds were launched over the decade while 2,400 were either closed or merged into other funds. That is a very expensive form of reincarnation for which private investors have paid dearly.  

David Norman, chief executive at low-cost fund provider TCF Investment, points out that not only have TERs risen, in the UK they often increase the bigger the fund becomes. Average TERs for funds with AUM of $400 million (£245 million) to $1 billion are 1.27 per cent in the US and 1.65 per cent in the UK. In the US, France and Germany TERs fall when AUM is greater than $1 billion – but rise to 1.67 per cent in the UK. As Norman points out: ‘In a retail market, this is unique.’

A fund industry veteran, Norman has produced detailed research that shows why the UK asset management industry is a ‘heads we win, tails you lose’ business model that does its constituency of private investors few favours. Norman adds that the sheer complexity of fund management charges effectively allows for price-setting, despite the fact that the huge supply of around 2,500 retail products should be driving price competition. 

‘I’ve had 28 years’ experience of watching the industry that has so much to offer destroy more and more value, and slowly ruin the great customer proposition of long-term financial security that it could so easily offer,’ says Norman. 

Who, then, will step up to the plate? The looming introduction of the Financial Services Authority’s Retail Distribution Review on 1 January 2013 has encouraged fund providers to launch, or relaunch, lower-cost funds. Fresh faces such as TCF are aiming to cut through complexity with low-cost funds that are gaining favour with the advisory community and the wider investing public.

But the new key investor information documents (Kiids) for funds, which are being phased in this year, do little to strip away the mystique surrounding fund charges. That is why we have reprinted our 2010 manifesto.

It’s a list of demands the financial services industry is unlikely to adopt. But private investors should consider all 10 points when assessing their current and prospective investments. In the coming months, Money Observer will be examining the true cost of investing in even greater detail. Watch this space. 

Accessing the 'on the road' cost

Funds that adopt lower charges are to be welcomed, but there are other potential costs to factor in. Gary Shaughnessy, UK managing director at Fidelity International, dubs this the ‘on the road cost’ of investing in funds. He is concerned that launches of low-cost funds in the run up to implementation of the Retail Distribution Review is muddying transparency and comparability, and he is calling for ‘fair pricing for all’. 

This idea extends to comparing passive funds as well as active funds. To this end, Fidelity has compared the ‘total cost of ownership’ on four popular passive funds held in an Isa for 10 years. In many instances, this is far higher than the quoted total expense ratio, as the table below shows. 

The Vanguard fund has the lowest TER at 0.15 per cent, but with a minimum investment of £100,000, if you want to purchase direct rather than via a fund platform, it’s beyond the reach of most private investors. Another point to remember is that some funds are only available on a few platforms, all of which will levy additional charges on top of the low headline TER. 

Shaughnessy suggests investors ask five key questions before they invest in any fund, active or passive: 

1) What’s included in the headline charge?

2) Are costs such as platform fees, advice or other fees added on top?

3) What’s the ‘on the road’ cost of this fund?

4) Is there a minimum investment that rules me out?

5) Is this the best way of purchasing the fund based on my personal circumstances and the impact on my tax liability?

£10,680 invested in an Isa and held for 10 years

Summary of fees

Notes: The table assumes an investment of £10,680 (the current Isa allowance) for a purchase made via a financial adviser, 7 per cent annual growth for 10 years and that is the purchase is made through the most cost-effective platform for each fund. *The 10 basis point platform charge is reflected in the fund's TER. Source: Fidelity.

Money Observer's manifesto for investment cost transparency

1) All potential investment charges should be listed on a single sheet supplied to new investors.

2) Investors should be informed of the typical buying costs for investment trusts, exchange traded funds, Oeics and unit trusts in all the literature relating to the funds.

3) All types of funds should publish basic total expense ratios prominently in their literature.

4) The previous year’s portfolio turnover rate should be published with the estimated cost of dealing and stamp duty, where applicable, expressed as a percentage charge.

5) Where performance fees are levied, regular annual management charges should be set at a minimum of 0.5 percentage points below the market average. Maximum fee limits should be introduced.

6) Performance fees should be shown separately and as part of an overall TER.

7) Performance fee structures should be made consistent or standard growth illustrations given so fee outcomes can be compared.

8) Improved benchmarks should be developed with performance fees based on a minimum of three years’ outperformance, and fee clawbacks should be introduced.

9) High water marks should be compulsory so managers can only charge another performance fee when their returns exceed a previous high point.

10) Potential dilution levies should be made clear for Oeic investors, and typical selling costs for investment trusts, exchange traded funds, Oeics and unit trusts should be prominently displayed in fund literature.