Best to invest where the fund fees are low

The best way to own common stocks is through an index fund that charges minimal fees, says Warren Buffett. Photograph: Getty Images
The best way to own common stocks is through an index fund that charges minimal fees, says Warren Buffett. Photograph: Getty Images
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As the cost of wealth management soars, Gordon Wilson points out the hidden charges which can hit returns

DO YOU know how much your investments cost you? Take a few minutes to examine the small print and you’re likely to find that it costs more than you have been told and more than you paid in the past.

Actively managed funds have increased fees in the past decade, with more than 90 per cent of those that changed their prices pushing them up, according to new figures from data analysts Lipper.

They have hiked fees by an average of 30 basis points. That might not sound like much, but if you were paying 1.5 per cent a year to your fund manager and that rose to 1.8 per cent, it would have a serious drag on long-term performance.

But do these higher costs equate to higher returns? Far from it. A study released this year by Morningstar, the fund investment specialist, found that cheaper funds tend to outperform the expensive ones.

The funds in the cheapest quintile – all of which would earn As for fees within Morningstar’s Stewardship Grades scheme, designed to highlight good long-term investments – had the best risk-adjusted returns, particularly over five or ten years.

Similarly, the majority of the most expensive funds underperformed the average Morningstar risk-adjusted return. Indeed, high-cost funds tend to have such poor performance that they are likely to be liquidated or merged with others.

It is no coincidence, then, that the world’s most successful investor, Warren Buffett, recognises the contribution of low investment fees to strong performance: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”

Costs kill performance. So, just what are you charged when you invest, and how can you reduce these fees? Let’s take a look.

Initial costs

The world of investment is riddled with jargon and acronyms that can confuse even the most astute of investors. Initial costs vary widely and come in all sorts of guises – from initial charges and establishment charges to reduced allocation, bid/offer spread and commission, to name the most common.

Costs can vary from nil in single-priced funds to 8 per cent as a commission. Don’t be fooled into thinking that, as the investor, you don’t pay the commission; you do, although it may not be clear how it is taken from you.

Annual costs

The annual management charge (AMC) only tells part of the story: this is only one of a number of costs borne by an investment fund every year.

It’s better to start by looking at a fund’s total expense ratio, or TER. Even this doesn’t include all of a fund’s expenses, but it does factor in things like legal fees, auditor fees, advertising and other operational expenses.

The typical mutual fund has a TER of 1.65 per cent per year, but this can be as low as 0.2 per cent on an index tracker – the vehicle Buffett would advocate.

Turnover costs

Actively managed funds are like an iceberg: often, what is below the water can be much more significant than what is above. Turnover cost is also borne by the fund, but few investors are aware of it, because fund houses rarely flag it up.

Every time a fund buys or sells holdings there are associated costs: stamp duty on UK share purchases of 0.5 per cent, commission paid to brokers and bid/offer spread (the difference between buying and selling prices).

We have calculated that, on average, this will cost a UK fund which turns over 100 per cent of its portfolio in a year an additional 1.8 per cent. The average UK equity fund turns over two-thirds of its holdings per year, adding 1.2 per cent to costs. So, turnover often leads to a near doubling of the TER, meaning most active managers have to achieve returns of around 3 per cent a year just to stand still.

These transaction costs rise in less liquid markets, such as emerging markets. An emerging markets fund with 100 per cent turnover will add 7.6 per cent per year to fees, according to Frontier Investment Management. With the average TER at 2 per cent for an emerging markets fund, you’d need a return of 9.6 per cent per year just to break even.

Advice costs

This isn’t the end of the story. There’s also advice cost. If you use a big investment management firm or bank to run your portfolio, you could also pay them a management charge of 1 per cent a year for picking funds and advising you on when to buy and sell. There may also be a commission for doing this, which is more difficult to quantify.

If you deal through a financial adviser, they are likely to be paid a share of the TER in the shape of trail commission, typically 0.5 per cent a year. It’s common practice for big investment managers to charge an annual fee and keep trail commission paid by the underlying funds. This practice of “double dipping” will be ended under new legislation coming into force on 1 January 2013.

Costs matter

The long-term additional return from equities over lower-risk assets, like government bonds, has historically has been around 4 to 5 per cent a year. If you’re paying charges approaching this, you’re likely to be taking a lot of additional risk for little extra return. In fact, most active managers underperform simple index trackers – meaning you could end up paying a lot for lower returns.

Just 16 out of 1,188 funds surveyed by Thames River Multi Capital were in the top quartile for performance in the three consecutive 12-month periods to end-March 2011. In other words, just 1.3 per cent have shown consistent decent outperformance.

Time to cut costs

Shaving just 1 per cent per year from your investment costs can have a massive impact on eventual returns.

Buying cheap tracker funds to get access to the markets you want to invest in can be achieved with no initial cost and annual charges of 0.2 per cent, with turnover costs of less than 0.1 per cent.

This could reduce your costs by over 90 per cent and boost your chances of investment success. Also think about adding exposure to small companies. Research by financial economists Fama & French shows that investors are rewarded for taking these additional risks.

And, when it comes to seeking financial advice, choose to pay a fee rather than the commission route: fees are far more transparent and generally work out cheaper. Fee-based wealth managers can often access investments at creation price or net asset value, meaning initial charges are waived.

So, buy into the market cheaply, using funds with the lowest management fees and turnover to give yourself the best chance of achieving the returns you deserve for the risks you’re taking.

• Gordon Wilson is a certified financial planner and managing director of Carbon Financial Partners