FE Trustnet reveals the different types of charges that can be applied to investment portfolios and the effect these can have on total returns.
Fees check-list
- Does the fund have a performance fee? If so, are similar alternatives available without such a fee?
- How does the TER or on-going charge correspond to other funds in the peer group?
- How has the fund performed in the past? If the manager has a track record of outperforming his peers, it may be worth paying more.
- Where can you buy the fund? Can you get a better deal through a fund supermarket or an adviser?
Total expense ratio (TER)
The most comprehensive, but not all-encompassing, figure listed on fund factsheets is the total expense ratio, a measure that includes any annual management charge (AMC) plus expenses such as auditor fees, stamp duty and other assorted regulatory expenses.
The figure is expressed as an annual percentage charge and if a fund has a performance fee then this will also be recorded in the TER. However, many industry commentators point out this is not the end of the story.
Lee Robertson, chief executive at wealth management firm Investment Quorum, said: "Only in financial services could the term ‘total expenses’ not mean total."
Trading costs
When managers buy or sell assets they usually pay charges to the brokers, referred to as trading costs, which are passed on to the client.
The more a manager buys and sells assets, the higher these costs are. This figure is rarely included in the TER of the portfolio because the total varies from year to year, meaning investors will never know for certain how much they will pay.
The Investment Management Association (IMA) argues that these costs should not be considered as charges because they are part of the day-to-day management of the fund – a manager buys or sells to produce returns, so an investor is not "charged" for such activity, it is what he or she is already paying for.
On the other hand, there is an argument that because investors should be able to see how much of their own money is being spent on transactions.
Gina Miller, chief executive of wealth manager SCM Private, said: "At the moment you have no idea how much you are paying and you have to wait for the annual report. Dealing costs are still left out and the claim is you cannot calculate it but you could calculate a three-year average."
On-going charges
In an attempt to make charges clearer, European legislation has mandated the introduction of Key Investor Information Documents (KIIDs), which feature an on-going charges figure.
This is more or less the same as the TER but does not include the effects of performance fees, on the grounds that these are not on-going but vary according to the success of the fund.
Performance fees
Performance fees are charged for beating a certain benchmark that the fund house chooses – if the fund beats its target then the management team will take a certain percentage of the gains – which could be as high as 15 per cent.
Performance fees are not common, and Robertson says investors should be wary of them.
"I’m not a massive fan of performance fees because they tend to be slanted to the fund management team. Investors can usually find an alternative without the fee."
Investors should check that the benchmark chosen for the measurement of the fee is appropriate. It should match the general makeup of the fund. All FE Analytics performance data includes the effect of a performance fee.
How fees affect performance
There is a heated argument surrounding the issue of charges and FE Analytics data shows additional fees can have a huge effect on performance.
Take, for example, the five crown-rated £2.3bn Trojan fund managed by FE Alpha Manager Sebastian Lyon; data from FE Analytics shows that just a 1 per cent additional annual charge on its performance over the past 10 years would have massively reduced its total returns.
While the fund – which has a total expense ratio (TER) of 1.03 per cent – has returned 165.03 per cent over the past decade, had it charged just a 1 per cent performance fee, the total return of the portfolio would be reduced to 137.7 per cent.
This would equate to gains £2,500 lower on an initial investment of £10,000.
Performance of fund vs bespoke measure
Source: FE Analytics
However, in spite of their importance, Robertson warns that investors should not get too obsessed by fees.
"If you have a fund with a long successful track record but it’s a bit more expensive then it may well be worth paying that bit extra for outperformance. There are lots of cheap funds that aren’t worth holding."
Miller agrees: "If you have a fund that’s outperforming its peers by 5 per cent then it would be a mistake to just look at the fees."
Where investors buy the fund can also make a big difference to how much they pay. Going directly through the provider may result in them having to pay an initial charge of up to 5 per cent.
"If you go direct it’s the most expensive way to buy funds," Robertson added.
"Alternatively you could buy through a discount broker such as Hargreaves Lansdown and that way you get discounted entry fees."
"Or, if you go through an adviser you may get access through a platform for institutional prices – which are much lower – but you will have to pay the adviser."
The Retail Distribution Review (RDR) legislation that comes into force in January 2013 bans commission payments from fund providers to advisers and requires that the latter charges investors for advice.
It is widely expected to force fund houses to lower their fees and also lead to many investors looking to bypass advisers and invest directly.
This concerns Robertson, who said: "Even if you have to pay adviser fees you may be able to get cheaper prices through an adviser if they are paying institutional prices."
He warns that platforms will still be able to strike deals with fund providers for at least another year, meaning that there will still be a lack of transparency in those arrangements, which investors will need to keep in mind.