When looking at potential investments it can be very tempting to base your decision on past performance figures alone, but it is extremely dangerous to overlook another vital component: charges.
Fees for investing in collective investment schemes vary enormously - particularly on open-ended investment companies (Oeics) and unit trusts - and can have a dramatic impact on long-term gains.
If one fund charges 0.5 per cent a year and another charges 1.5 per cent, the more expensive fund will have to produce an extra 1 per cent just to keep pace. That 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 growing by 7 per cent each year will reach £22,190 after 10 years before costs are added into the equation.
However, annual charges of 1.65 per cent would reduce this to £19,000, whereas fees of 2.5 per cent would shrink it to £17,520.
Meanwhile, some low-cost index-tracking funds have annual charges of 0.3 per cent, 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 haven't been particularly transparent, although the situation is beginning to improve. What charges apply and how much they are going to set you back can vary enormously.
First is the annual management charge (AMC) and then other costs, which, when added to the AMC, will be expressed as the ongoing charges figure (OCF), which used to be known as the total expense ratio (TER).
However, this isn't the full picture as there will be other running costs and dealing charges on top of the OCF, which will impact more on funds that have a high portfolio turnover. That is particularly true for UK equity funds, where stamp duty of 0.5 per cent is levied on share purchases.
On top of this, some funds (and investment trusts) also levy a fee if the fund surpasses a predetermined performance level. This 'performance fee' could be based on an absolute measure, such as Bank of England base rate, or outperformance of a selected benchmark, such as 5 per cent more than the annual performance of the FTSE 100 index. In the latter example this could mean investors end up paying a performance fee even if the fund loses money, but doesn't lose as much as the reference benchmark.
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 0.25-0.5 per cent.
Another way to reduce the cost of investing in open-ended funds is to make sure you choose the correct share class. In the past, fund management groups bundled up all sorts of charges into the typical 1.5 per cent AMC.
In fact, most actively managed equity funds typically levy a 0.75-1 per cent AMC. The rest is divided between fund distributors: financial advisers get a 'trail' commission and fund platforms can also receive this commission and an extra platform fee for offering a fund to investors.
So it's important that if you are a self-directed investor, you make sure that you can take advantage of rebates on these extra fees that some fund distributors offer. Some fund platforms - also known as fund supermarkets - offer a full rebate and others just a partial rebate.
This is particularly pertinent for investments made before 6 April 2014. Because these do not count as 'new' investments, financial advisers and fund platforms can continue to collect trail commission on funds that you hold. This can apply not only to a lump sum investment you made in the past, but also to contributions via regular savings.
Investors who are not receiving a rebate on the old-style share classes could be losing 0.5 per cent a year on these legacy investments until 5 April 2016. At that point all legacy fund investments must be switched into a clean share class.
Investors have another option, which is to switch into the so-called 'clean' share classes. Most fund management groups have now launched these in response to the Retail Distribution Review which was implemented on 31 December 2012. Its main aim was to seek to eliminate so-called 'commission bias' on investment recommendations. Some, but not all, fund platforms and supermarkets are already switching clients into clean share classes.
In their purest form, clean shares classes include only the fund manager's annual fee, although some also continue to include a platform fee.
Choosing a clean fee share class means less potential drag on fund performance, but it also means less paperwork - HMRC taxes cash rebates on funds that are not held in a stocks & shares Isa or personal pension.
From 6 April 2014 any new investments into open-ended funds must be via a share class that has trail commission stripped out. However, as mentioned previously, regular investments can count as ‘ongoing business’ until April 2016.
Active versus passive in the ‘clean’ fund world
In the past, you might have been paying 1.5 per cent to own an actively managed fund and 0.25-0.5 per cent to own a passive fund. Even if you were receiving a small commission rebate on the active fund, the difference was up to five or six fold.
Now, if your fund provider charges you an additional percentage-based fee for holding assets on a platform, you’ll pay a typical 0.75 per cent for the fund plus an average 0.35 per cent platform fee. That amounts to 1.1 per cent for the active fund compared with 0.6 per cent (0.25 per cent plus 0.35 per cent) for the equivalent passive fund.
That equates to less than half the difference previously. For many investors, choosing a platform that levies a flat fee could be more cost-efficient.
You may also want to consider exchange traded funds (ETFs), which have grown in popularity over the past decade. These provide access at relatively low cost to a wide range of different investments: including exposure to countries as diverse as the US or Vietnam; asset classes from gold to emerging market bonds; and growth or income-oriented strategies.
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. However they do not attract 0.5 per cent stamp duty on purchase, as with other listed shares. They can also be traded at any time, offering investors much greater control in terms of timing.
CONSIDER INVESTMENT TRUSTS
It is also worth looking at investment trusts, because their AMCs are often lower than on equivalent open-ended funds. However purchases of investment trusts are subject to stamp duty of 0.5 per cent of the amount invested.
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 per cent of the income they receive from dividends 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 for income-seekers.
Trusts can also gear-up, or borrow money, in the hope of generating a higher return than the cost of the loan. If successful, it will magnify gains, but is likely to leads to bigger losses in falling markets.
Some open-ended funds have a mirror investment trust, which will almost always be cheaper.
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 and pension allowances.
Unless a financial adviser is administering funds on your behalf, you should also try to cut the overall cost of investing by ensuring you are getting the best deal possible via discount brokers and fund supermarkets.
We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.
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