How much do your funds really cost you?

Fund charges act as a drag on the performance, but they are not as transparent and easy to quantify as you might think.

Charges can have a bigger influence on an investors’ returns than most people realise because of the compounding effect over time. For example, a £10,000 initial investment in a fund with an annual cost of one percent that achieves a yearly return of six percent over a five year period would grow to £12,763. If the annual cost was just 0.5% the final value would be £13,070, an increase of £307.

The annual running costs vary from one fund to another and will depend on a number of factors including: the fee charged by the investment management company; whether it is structured as an investment trust or an open-ended fund; the size of the fund, with the fixed costs having a disproportionate impact on smaller vehicles; and the transaction costs that are incurred whenever the fund manager changes the portfolio.

Another issue to take into account are the upfront costs. There is not normally an initial charge when investing in an open-ended fund, whereas buying an investment trust would incur stamp duty and commission. Most platform providers also levy an annual custody charge based on the value of the holdings, although in some cases it is capped at a fixed maximum amount per annum.

Doesn’t tell the whole story

The annual management fee, as well as other running costs such as administration, marketing and regulation are all summarised in the Ongoing Charges Figure (OCF) that is quite prominently disclosed, but it doesn’t tell the whole story. You will get a better idea if you look at the Key Information Document (KID) or the fund’s annual accounts.

Take the Fidelity Special Situations W-Accumulation open-ended fund as an example. This has an OCF of 0.91% and direct transaction costs for the year ended 28 February 2019 of 0.23%, which pushes the total effective cost to investors to 1.14%. Although not relevant in this instance, any performance fee would also be separately disclosed.

The costs would be different for an investment trust, such as Fidelity Special Values (LON: FSV), which is the nearest equivalent to the previous open-ended fund. According to the relevant KID, this shows ongoing costs of 0.92%, while the accounts for the year ended 31 August 2018 – they are made up to a different date to the open-ended fund − disclose transactions costs of £1.75m, which is approximately 0.24% of the year-end NAV, giving a total of 1.16%.

Whenever investors buy or sell units in an open-ended fund the money flows into or out of the portfolio and has to be invested or disinvested accordingly, which could give rise to additional transaction costs. This is not the case with an investment trust where the shares change hands on the stock exchange and the manager is left with a fixed pool of capital to invest.

For comparable portfolios the extra transaction costs shouldn’t make much of a difference as a percentage of the overall assets, although in falling markets trusts probably have the cost advantage as they aren’t having to sell to redeem investors.

Investment trusts versus open-ended funds

Research conducted by platform provider AJBell earlier in the year looked at 40 pairs of comparable open-ended funds and investments trusts. These compared pairings run by the same manager following a similar strategy.

They found that in 60% of the cases the investment trust was the cheaper vehicle with a lower OCF. This probably helps to explain why in 75% of the pairings the trust outperformed the fund on a total return basis over a ten year period. The open-ended funds in the group had an average OCF of 0.97%, while the equivalent figure for the trusts was 0.91%.

The main downside was that 90% of the time the trust was more volatile than the equivalent fund. Part of this would have been due to the gearing, with trusts able to borrow money to boost the potential returns. The other main reason would have been the fact that their shares can trade above or below the NAV of the underlying holdings.

One final point to note is that index trackers are much cheaper than their actively managed counterparts and they have been growing in popularity in recent years. This is putting pressure on investment firms to reduce their fees, but there is still a significant differential that an active manager would need to overcome to justify their higher charges.