‘Clean’ investment funds growing in popularity

A GROWING number of investors are taking advantage of the emergence of a new breed of funds that come free of hidden charges.

Demand for “clean” funds, which do not include any trail commission, is on the rise following regulatory changes designed to make the cost of investing more transparent.

The payment of commission on the sale of investment products was banned at the end of last year, under radical reforms known as the retail distribution review (RDR).

The main aim was to stamp out mis-selling and make it far clearer to investors what they are paying for financial planning advice, investment management and underlying  investment holdings.

The new rules only apply to investments made after the end of 2012, and trail commission – typically a 0.5 per cent annual charge on the value of your fund, which management groups give to financial advisers, fund supermarkets or other investment platforms for as long as you hold the fund – continues to be paid on existing investments.

However, the Financial Conduct Authority last month published new rules for platforms that effectively sounded the death knell for these legacy commission revenues, with most trail payments now likely to dry up by 2016.

Investing website Candidmoney.com gives the following example of how trail can deplete your nest egg over the years: a £50,000 portfolio of unit trusts typically pays around £250 trail commission a year. Assuming an annual investment return of 6 per cent, trail commission of 0.5 per cent would reduce your return over ten years by almost £3,800.

Some discount brokers and fund platforms rebate trail commission to investors. This kick-back from the fund manager to you or your platform provider can help to reduce the overall cost of your portfolio or offset your  adviser’s charges.

Sounds good, right? Well, to complicate matters, from the start of the 2013-14 tax year, trail rebates became subject to income tax,  unless the payment is made into an individual savings account or self-invested personal  pension.

This means investors will find their rebate reduced by basic rate tax, currently 20 per cent, while higher-rate taxpayers will have to declare it on their tax returns – making clean funds even more attractive. The benefit of clean funds is that they do not include trail commission in the first place, so less of the capital investment gets eaten up by additional charges.

As any trail commission rebate is paid back to the investor separately, it will not contribute towards the growth of the investment. In fact, an investment of £50,000 in a clean fund with an annual management charge (AMC) of 0.75 per cent over 20 years has the potential to accumulate almost £20,000 more than a fund that charges an AMC of 1.5 per cent over the same period, according to stockbroker TD  Direct Investing.

Most advisers will now look to move their clients to clean share classes that have lower overall costs and no rebates, but not all investment platforms have made these available.

What should you pay?

If total investment charges are like an onion, the first layer is the cost of underlying investments. These can be as little as 0.2 per cent for an exchange traded fund (ETF) to around 2 per cent for an actively-managed fund-of-funds. The cost of investing in a fund is broken down into the AMC and the total expense ratio, which also includes additional fund management expenses, such as those incurred when trading stocks within a fund.

Financial advisers are increasingly using cheaper “passive” investments, suich as ETFs and trackers, in an attempt to bring down the total ongoing cost to clients. Research indicates that active managers, on average and over longer periods, do not outperform the market. However, there are a number of investment managers who can demonstrate a track record of consistently beating the sector average without taking any more risk than the average of the market they specialise in.

Investors can consider a mix and match approach between the two styles, buying into index trackers in high efficient markets like US large caps, where managers can find it difficult to outperform, and selecting active funds in less efficient markets, such as US smaller companies, where there are more stock-picking opportunities.

Cost of investment management

Asset allocation – the blend of asset classes – is the biggest determinant of portfolio returns. In the post-RDR world, many financial advisers have chosen to outsource the responsibility for asset allocation to discretionary fund managers (DFMs). Costs range from as little as 0.25 per cent of the value of your investment each year to as much as 1.5 per cent. They are usually tiered so that you pay less, as a percentage, the more assets you hold.

Since the introduction of the RDR and the unbundling of these charges it should be easier to see what you are paying and then compare the performance of your investment to a  passive investment that does not have an active manager.

Cost of financial planning advice

Before the introduction of the RDR, many people – quite mistakenly – believed financial advice was free. However, any commission paid to your financial adviser would have been deducted from your investment in some shape or form.

Now that commission has been removed for post-RDR investment and pension advice, advisers are remunerated by way of fees. These can either be paid directly or taken from your investment and pension pots.

These tend to range from 0.5 per cent to 1 per cent of the value of your investments, depending on the level of service provided, though some advisers charge an hourly or fixed fee instead.

Reconcile what you pay upfront and on an ongoing basis with the financial plan and quality of service you receive. In the post-RDR world, it should be easier for you to see what you pay and to whom.

Make sure you assess whether or not you are getting value for your initial and ongoing payments, while remembering the famous Warren Buffett adage: “Price is what you pay, value is what you get.”

• Jason Hemmings is a partner at Edinburgh-based Cornerstone Asset Management