Everyone knows that charges matter, and that overheads act as a drag on your investment performance. However, it isn't always realised how drastically even apparently modest charges can eat into your long term returns. This is particularly so for funds, where fees are levied as an annual percentage. The better your investments perform, the more charges take from you as the years go on.
Take the example of a 1 per cent annual charge for a fund. That may not sound too bad, but for an investor contributing £100 a month, and who averages a gross return of 7 per cent for 25 years, the total cost is a shade over £10,000, cutting your total net investment by 15 per cent to £65,800. However, if you managed 10 per cent a year over the same period, the fees would leap to £16,470. Though your average annual returns have increased by 42 per cent, the total fees payable have increased by more than 60 per cent.
The mathematics of annual fees are really just the same as the compounding used to work out annual returns. What it demonstrates is that it is at least as effective a use of time to find ways to reduce overheads, to find a really cheap stockbroker, or find a lower cost fund, than it is to try to achieve the more hit-and-miss objective of raising overall returns by enough to compensate. First, the effort for the fees is a one off, with a clear result every year. By contrast, seeking better performance, either by stock-picking or with funds by trying to find consistent outperformers, is something that requires repeated and sometimes continuous effort. Moreover, as a look through the types of afflicted investment show, a determination to tackle fees, costs and overheads inevitably ends up simplifying an investment portfolio, which is a good end in itself. A thorough review, cutting out multiple brokerage accounts, consolidating holdings in a low cost account, tackling that odd certificated holding, and unifying the old PEP with your current ISA can each save useful cash, money that can instead be earning its keep in the market. Some of the simplest ways to avoid unnecessary costs is to use a fund supermarket or an IFA which will discount or eliminate up-front fees. “With unit trusts, for example, you can pay up to 5 per cent up-front if you go direct to the provider,” said Adrian Lowcock, senior investment advisor at Bestinvest. "Not enough individuals are aware that you can avoid that up-front fee," he added.
For owners of tracker funds, the good news is that the arrival of US mutual fund group Vanguard in the UK is already helping to lower charges across the industry (see ). It has launched a collection of 11 trackers with a total expenses ratio (TER) as low as 0.15 per cent, compared with typical fees for UK rivals of 0.5 to 1 per cent. The snag, though, is that you will need to invest a minimum of £100,000 and can only get the products through a fee-based IFA, or a fund supermarket. Still, HSBC has responded by slashing the charges on its own index trackers from as much as 1 per cent to 0.25 per cent. To allow it to do so, it is no longer offering commission to financial advisers on its range of funds. HSBC is a minnow in this field, with only £700m under management, but that may change. Other low cost trackers include the Fidelity MoneyBuilder UK Index fund with a TER of 0.27 per cent, and the F&C FTSE All Share Tracker fund with a TER of 0.35 per cent.
Trackers are such plain vanilla products, that the choice of one over another on a given index should come down quite simply to the tracking error (which is how closely it follows the benchmark index) and above all the costs. Expensive trackers are just no good. The Virgin FTSE All-share tracker, launched in 1995 with a TER of 1 per cent, has underperformed its benchmark index by 33 percentage points to date precisely because of that fee. It has risen by only 109 percent including reinvested dividends, according to Morningstar, compared with 144 per cent for the underlying index over the period. That means £10,000 invested across the index at the outset would be worth £24,400, while those who decided to track the index with Virgin would be £3,500 out of pocket, with a fund worth just £20,900. Fidelity International has calculated that investors waste £40m a year by paying too much for trackers. With TERs as low as 0.25 per cent, there clearly isn't any reason to pay more.
Things are a little more complicated with actively managed funds. The very best funds, with the longest and most consistent track records may well be worth paying extra for. However, the average actively managed fund has a TER of 1.63 per cent according to Lipper, but has failed to justify that by outperforming. "The truth is that a lot of fund managers underperform trackers," noted Bestinvest's Lowcock. "Roughly 30 per cent of active managers outperform (once fees are accounted for) over the course of the economic cycle," he said.
So while there may be good reasons to pay a higher annual fee, you need to make sure that you are getting what you pay for. That is always going to be less likely when a product is complex. The fund of funds, for all the laudable aim of spreading investments widely, is surely just a recipe for adding fee upon fee and burying it within the whole.
The good news
There is good news however, both for owners of individual shares and funds. A study by consultancy Oxera for the EU found that share trading costs within the EU fell by 80 per cent between 2008 and 2006. This refers mainly to the costs levied by bourses on transactions, rather than the cost of commissions by brokers. But it remains good news nonetheless, and evidence of a positive trend which should ultimately emerge in lower fund costs. The costs of running portfolios of international shares fell too, but still remain twice as costly as deals conducted within national borders.
The gradual move by the industry towards clear and easy products that are bought by well-informed investors and away from complex propositions that need to be actively and expensively sold is a step in the right direction. A huge step in this direction has been the FSA's proposal to force IFAs to offer products from the entire market place, and be banned from taking commission fees by providers. This should finally provide the level playing field that investors need.
Individual shares
Holders of individual shares do have one advantage for all their extra stock-picking work in that they pay up-front for a transaction, and have relatively few overheads beyond that. Stamp duty at 0.5 per cent of the transaction value is a pain of course, but dealing commissions of £10 or less are now pretty common. If you trade a great deal in companies that don't pay dividends, you may as well go the spread-betting route which, under current tax rules, saves you the stamp duty and is free of capital gains tax to boot. There is very little difference in spread, particularly for larger companies, compared with the London Stock Exchange.
Investors in smaller companies have a particular problem with spreads, the sometimes very large difference between bid and offer prices on a share. Even if you just buy once and sell once in a year, in a company with a bid offer spread of 5 per cent, you will have to make 10 per cent just to stand still. There are clear advantages to a buy-and-hold policy in such cases.
For individual shareholders, the fees for 'tax-wrapping' of holdings is much less of a problem than it used to be because of increased competition among providers and a wider variety of products available. Self select ISAs can be had for £20 a year or less, though if you have funds within them you may be charged an annual percentage fee. Self Invested Personal Pensions (SIPPs) usually charge a little more, though a few charge no annual fees, while four (Killik, James Hay, Fidelity and Hargreaves Landsdown) do not charge a set-up fee. Most SIPPs charge more for trades than an ordinary stock market account would. Clearly, stocks that you might want to trade actively should be held within the type of account where the overheads for doing so are lowest. The level of interest you get on uninvested cash is also something worth examining closely for both ISAs and SIPPs, as are the transfer charges that you may incur if you decide to move to another provider. Always see if your new provider will rebate these charges for you. Many will.
A common problem for investors seeking the most sophisticated retirement planning is to pick a SIPP which allows the full range of investment choices, including owning commercial property. This tends to attract a hefty set up fee, but then for one reason or another investors often do not put enough away to justify the charges incurred, or after losses find themselves with an inefficiently small pension pot. For those, like the self-employed, who cannot always be sure that they can afford to put in as much as they originally planned, it can be wiser to pick a less sophisticated and cheaper SIPP which will tick over even on modest contributions.
In almost all cases, a frank look at your own requirements, a few hours shopping around and some scrutiny of the small print pays dividends that will boost your returns for years to come.
What is included in charges?
The real measure of charges is the total expense ratio, TER. This is calculated as all expenses divided by the total assets of the fund. It includes not just the initial or annual charges which you may pay on a fund or investment vehicle, but also the costs imbedded within it such as administration, marketing, legal, trustee and audit costs plus any capital gains taxes paid by the fund. When you get your annual or bi-annual statement from your funds provider, you are unlikely to see charges broken down as a separate item. Normally charges are deducted from any dividends or income that the fund pays.
Exchange traded funds (ETFs) are another way to clamp down on charges. These are entire baskets of shares traded as a single security, and are constructed to have low overheads. With an average TER of 0.5 per cent, they are not as low as the best trackers, but ETFs take you closer to particular market subsets than most trackers. For fixed income, ETFs are very competitive, with TERs averaging just 0.19 per cent. UK investors pay no stamp duty on ETFs, though you will pay commission just as if you were buying an ordinary shares.
Where the true costs are hidden
There are thousands of different kinds of financial product where the actual cost is not obvious to the investor. Perhaps the most notorious of these were the with-profits and endowment policies sold in the 1970s and 1980s, where investors lost out at almost every stage of the process because of a complete lack of transparency and flexibility. First, such funds were usually actively sold by commission-based financial advisers, who might then receive up to the first 18 months of your monthly contributions as payment before the first pound ever got invested. Then the ‘smoothing’ process of annual and terminal bonuses completely obscured the actual underlying performance of many of the investments contained and the high charges applied. Finally, anyone wishing to cash out before the policy reached maturity was, and still is, likely to receive a massive penalty, known as a market value reduction. In many cases such policies when surrendered to the originating insurer might return less than was contributed.
However, almost everything that made with-profits an investment disaster is still alive and well. More than 25m people still have a total of £400bn tied up in such products, particularly with-profits bonds which were heavily promoted in the 1990s. Though they have a wide variety of assets, from bonds to property as well as shares, within them, their high costs leave them vulnerable when markets perform poorly. Website Exitwith-profits.co.uk says: "With-profit investment bonds... were sold as the investment for all seasons, when in fact they leave you in the rain without an umbrella when it starts to pour."
Perhaps the worst offenders for hidden overheads now are structured products. There are a bewildering variety of these hybrid vehicles, the largest subset of which are guaranteed equity bonds. They offer various permutations of stock-market linked performance, guaranteed returns and capital protection. It is hard enough to work out what the returns are likely to be, but the imbedded costs of constructing them from bundles of derivatives are even more opaque.
