Buying an investment fund is unlike almost any other purchase you will ever make as you are not told upfront how much it is going to cost you. The best available estimate is the ‘ongoing charges’ figure, which is disclosed in the associated literature, but it does not give you the full picture.
A fund’s ongoing charges include the annual management charge levied by the fund manager, as well as admin fees and other expenses, with the main omission being the transaction costs. These are incurred each time that a fund buys or sells an investment and they can really mount up for an actively managed fund.
The regulator, the Financial Conduct Authority, has recently looked into this whole area and has said that it would support the move to an all-in fee for retail investors that includes the transaction costs.
This would mean that the fund manager would have to estimate the trading costs that they expected to incur during their financial year and if they went over this they would have to pay the excess themselves rather than pass it on to investors.
Despite their support for this measure the regulator has stopped short of enforcing it and has said that there would be further consultation with the industry before any changes were brought in, which suggests that it is far from a done deal.
Critics say that including the likely transaction costs is like buying a new car and asking for an estimate of how much the petrol is going to cost you, but it is more accurate to think about it as the expected servicing costs, which is a much more reasonable figure to ask for.
Even relatively small additional costs can have a surprisingly large effect on the long-term returns due to the compounding effect over the years
All of these charges are automatically deducted from within the fund as they are incurred, which means that investors never really know how much they are paying. Even relatively small additional costs can have a surprisingly large effect on the long-term returns due to the compounding effect over the years.
For example, a £100,000 lump sum investment in a fund that grew at 7% per annum before fees would increase to £169,298 over 10 years assuming the total annual charges were 1.5%. If the costs were half that at 0.75%, the fund would grow to £182,497.
The problem is exacerbated by the lack of price competition, especially for active funds sold to retail investors, which the regulator says has resulted in persistently high levels of profits earned by asset managers.
They have proposed various measures to remedy the situation including strengthening the duty on fund managers to act in the best interests of investors and the introduction of a rule requiring boards to assess whether the fund has provided value for money, but these seem unlikely to have any significant immediate impact.
It is easy to see why cheaper and more transparent alternatives like Exchange Traded Funds (ETFs) have grown in popularity, but these are much simpler products that aim to match rather than their beat their benchmark and would be extremely vulnerable in the event of a market sell-off.
Despite the lack of transparency, a good actively managed fund can still play a valuable role in your portfolio. The key is to look carefully at its objective, where it invests and whether it has consistently beaten its benchmark. If it ticks all these boxes the extra charges could be money well spent.