Managing Your Cash Flow
Invest in businesses? Find out about hidden charges now!
7 min read
11 November 2013
A more positive consequence of the financial crisis and lower expected investment returns is a dawning amongst business investors about the huge difference fund fees can make to what they ultimately receive in their pockets.
In addition, the new rules introduced recently as part of the ‘Retail Distribution Review’ are aimed at improving transparency in relation to the cost of investing and receiving advice. This should help investors make informed decisions and ask their investment advisers some challenging questions about the fees they are paying – not only the headline rates, but the additional costs borne by their investment or pension portfolio.
There is little evidence, however, of price competition in the UK, with Lipper research finding that among funds that had changed their fees between 2001 and 2011, 80 per cent had raised them.
In 2009, the UK had the fourth highest total charges out of 19 countries (ranked by country of domicile). UK funds charged 79 per cent more than US funds. And according to the research by the Financial Services Authority (FSA), on average only 50 per cent of total fees were being disclosed to consumers prior to purchase.
Costs are still too high
Despite the new rules, the average total expense ratios on UK All Companies equity unit trusts are around 1.6 per cent of the fund value every year (before adding the cost of advice and administration fees). And then additional portfolio trading costs (most of which are not disclosed to the investor) can add a further 1.0 per cent. That gives an annual cost hurdle of around two per cent that most active fund managers needs to overcome before they even start. If you then factor in the effect of inflation, the average investor buying traditional, active funds needs to experience fund growth of almost five per cent a year – just to stand still!
Why are costs important?
Costs are an ever present drag on investment performance and it is very important to be aware of the compounding effect of this in the reduction of your potential investment returns.
Using the above industry average of a 1.6 per cent a year annual charge; based on an initial investment of £100,000 and ten per cent annual returns, after 30 years, the investment before expenses will have grown to £1.7m. However, compound expenses over this period would amount to £0.6m and reduce the net returns by roughly 35 per cent.
Your investment costs checklist
- Are all investment costs made clear and shown separately in the fund documentation?
- What are the total costs, including those not disclosed within the Total Expense ratio?
- Which investment costs will I pay up front and which are paid by the fund?
- Is stamp duty (where applicable) collected from the fund or the individual investor?
- Are the fund’s running costs paid for by the annual management charge or the fund? and
- Does the fund’s cost represent real value for money?
The alternative – index investing
Index managers believe it is difficult to out think the market, so they try to match the performance of the market. They usually do this by closely following or tracking an investment index, such as the FTSE All Share Index which includes all companies listed in the UK.
Benefits of index management
Index investing keeps management costs low. Why? Because with an index fund, there is no need to spend resources to research individual companies. Trading costs are also reduced because securities are bought and sold much less frequently.
By contrast, “Active Management” is based on an approach which usually seeks to beat the return from the market. In doing so the manager will take bets and will often trade in and out of securities on a frequent basis to seek additional returns and to outperform the other funds and managers in the sector.
On average, most active managers have failed to beat their benchmarks over five, ten and fifteen years, often due to high charges and costs of trading. Many investors are now waking up to the fact that they are paying high fees for mediocre performance.
Stacking the odds in your favour
A recent report from Morningstar found that low investment fund fees were better than their own “star” ratings system in predicting future winning funds.
“If there’s anything in the whole world of mutual funds you can take to the bank, it’s that expense ratios help you make a better decision”, the study’s author Russell Kinnel said, noting that in every single time period and data point tested in the four year study, low cost funds beat high cost funds.
Reducing costs is the only ‘free lunch’ in investing. A pound of costs saved is no different to a pound of market performance in monetary terms, yet it is far more valuable due to its consistency over time and the fact that it is achieved without taking any risk. Minimising costs in your investment programme can have significant benefits over time, through the effects of compounding up each year.
Costs and fees make a real difference – and it has never been more important to understand the total costs you are paying and to work with a wealth adviser who focuses on using proven methods and independent academic research to help keep costs to an absolute minimum.
It can be helpful to seek an impartial review and to obtain a “portfolio x-ray” outlining the total fees you are currently paying in order that you may make a fair judgement as to the value you receive.
Alan Smith is CEO of Capital Asset Management