The charges you pay to a fund house for looking after your money can have a significant effect on the returns you ultimately receive, making it critical to understand how they work.
You should also not automatically assume that charges on an Exchange Traded Fund (ETF) are always better value than an actively managed fund, as in many cases they are not.
There are various charges/fees applicable to funds that are important to understand before deciding to invest, such as:
- Does the fund have a performance fee? If so, are similar alternatives available without such a fee?
- How does the Total Expense Ratio (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?
These can range from 0 per cent up to 5.5 per cent and are usually for the benefit of the financial adviser to act as an initial commission. The majority of high street banks in the UK charge between 3 per cent – 5 per cent but many on-line brokers and ourself do not charge any initial charge.
Total expense ratio (TER)
The most comprehensive, but not all-encompassing, figure listed on a 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 of the total amount the fund has under management, and if a fund has a performance fee then this will also be recorded in the TER. However, this is not necessarily the end of the story. Only in financial services could the term ‘total expenses’ not mean total.
When managers buy or sell assets within the fund they manage, 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 a 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.
At the time you invest, 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 by most fund managers is that you cannot calculate it but you could calculate a three-year average.
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 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 15/20 per cent.
Performance fees are not common but you should be aware of them before you decide to invest.
Investors should check that the benchmark chosen for the measurement of the fee is appropriate. It should match the general makeup of the fund.
How fees affect performance
There is always debate around the issue of fund charges and there is no doubt that additional fees can have a major impact upon performance.
For example, the five crown-rated £2.3bn Trojan fund managed by 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.
However, in spite of their importance 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 plenty of cheap funds out there that aren’t worth holding.
In other words. 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 you buy the fund can also make a big difference to how much you pay. Going directly through the fund house may result in you having to pay an initial charge of up to 5 per cent.
Alternatively you could buy through an on-line discount broker and 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 adviser costs to take into consideration.
The Retail Distribution Review (RDR) legislation that comes into force in January 2013 bans commission payments from fund providers to financial advisers and requires that the investors are charged separately for advice, thereby making charges/fees more transparent to the consumer.
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.
However. even if you have to pay adviser fees you may still be able to get cheaper prices through an adviser if they are paying institutional prices.
Platforms will still be able to strike deals with fund providers for at least another year, meaning there will still be a lack of transparency in those arrangements, which investors will need to keep in mind.