Investing Knowledge

By Emma Tyrrell

Investors in the UK have always picked their investment funds blindfold, with no idea of the true costs nibbling away at their returns.

Although fund managers have published initial charges and annual management charges, they've been allowed to leave out other expenses, such as marketing and legal costs, which can drag on a fund's performance. These hidden extras aren't just small change either, as they can often double a fund's advertised annual fees.

But not any longer. From Saturday the rules change, forcing fund managers to reveal "total expense ratios" (TER) to investors, showing the annual management charge and all other annual running costs as a percentage.

That's bad news for Invesco Perpetual UK Recovery, which out of all funds investing in UK equities currently holds the crown for heftiest TER. Its advertised annual management charge is 1.5 per cent, but its TER is a whopping 3.22 per cent.

At the other end of the actively managed scale is the Royal London Equity Income Trust, which has an annual management charge of 0.75 per cent a year, but a TER only a little higher at 0.88 per cent.

Tracker funds, which use computers to follow stockmarket indices instead of employing expensive fund managers, tend to have lower annual management charges than actively managed funds, and lower TERs as a result. Abbey National Stockmarket 100 Tracker Growth for example, has an AMC of just 0.35 per cent, and a total expense ratio to match. It's no longer the cheapest, however, as Fidelity recently slashed the cost of its Moneybuilder UK Index fund from 0.5 per cent to just 0.1 per cent, bringing the TER down in turn to 0.3 per cent.

Currently the only source of comparable TERs is from a company called Fitzrovia, which specialises in providing the information. Its figures are shown on the Investment Management Association's website ( www.investmentfunds.org.uk ) where you can rank funds by initial charge, annual management charge or total expense ratio.

The move to make fund managers publish their own TERs comes at the same time as a report showing that UK investors pay much more for their investment funds than consumers in the US . The report, from Fitzrovia and Lipper, shows that the average total expense ratio for US equity mutual funds, weighted by assets, is just 0.92 per cent, compared with 1.68 per cent for UK funds.

The difference is partly down to the larger size of US funds, and the consequent economies of scale they enjoy in running costs. But US fund managers also tend to pass some of these economies of scale on to investors, by using tiered management fees, which decrease as the fund grows in scale.

In recent years, US funds have been getting cheaper, while UK funds have actually been getting more expensive. Although Fidelity's cost-cutting move may spark a price war between tracker funds, some active fund managers, including M&G, Credit Suisse Asset Management, and Threadneedle have recently increased annual management charges.

Does all this really matter?

The odd percentage here or there may sound insignificant, but even small differences in total expense ratios can have a big drag effect on your fund. Fitzrovia gives an example of two funds, A and B, which each have an annual management charge of 1.5 per cent, and each grow at 7 per cent a year. However, while fund A has a total expense ratio of 1.55 per cent a year, returning 5.45 per cent to the investor, fund B has a TER of 2.25 per cent, leaving just 4.75 per cent for the investor.

Over ten years, assuming the fund expenses stayed the same, a £7,000 investment in fund A would grow to £11,900, while the same amount invested in fund B would be worth just £11,134. That's £766 difference, enough to pay for a decent holiday.

But surely you get what you pay for with fund investing?

In the example above, both funds have the same annual management fees. The extra fees which make up the difference between the two funds are going towards running expenses, not investment management, so you're not paying for any extra fund quality with fund B, just more marketing and other expenses.

All other things being equal, you will obviously do better with a cheaper fund, as high-charging funds have to grow faster to make up for the extra costs .

However all things aren't equal. Some active managers do provide good value for money, and manage to outperform despite their higher charges. If you can find a manager that consistently outperforms the competition, you'll probably be happy to pay the extra. High charges are no guarantee of high performance however. A survey in Money Management magazine earlier this year found that investors were paying similar charges for top-performing funds, as they were for the real investment dogs. It showed that the average annual charge on the 20 worst performing funds in any investment sector was as high, or sometimes higher, than the average for the 20 best performing funds in that sector.

What costs are included in the TER?

A fund's total expense ratio represents the drag on performance caused by all annual operating costs. This includes the annual management charge, but can also include custody/trustee costs plus audit, legal, marketing, directors, printing and other expenses. These additional charges may not always be incurred, or charged for.

Why do some funds have such big differences between their AMC and TER figures?

Often this will be because the fund is small, holding just a few million in assets. Smaller funds will be disproportionately hit by certain operating costs, which will represent a much bigger percentage of assets. Invesco Perpetual UK Recovery fund, which was used as an example above, has assets of under £5 million.

Is there any way to save on fund costs?

Initial charges on investment funds typically knock around 5 per cent off your investment value straight away, but it's pretty easy to save on them. Unit trusts and Oeics, whether held in an Isa wrapper or not, are usually available through discount brokers, with either all or a major chunk of the initial charge knocked off. Discount brokers will not offer advice, but some financial advisers may also offer a discount, albeit smaller. Bear in mind that if you buy direct from the fund manager, you will pay more than you will through a discount broker.

A few brokers, such as Hargreaves Lansdown, also offer a discount off annual charges, in the form of a loyalty bonus.