IN RECENT years investment returns have been good so investors have not focused on charges, but that will change if markets are flat or fall.
Accordingly, it is worth giving charges consideration as they can have a big impact over the longer term.
Investors need to decide if the potential outperformance of a fund justifies a higher fee than, say, an index tracker.
Consequently, investors need to consider both investment returns and charges.
In the past, funds reported a charge applied by the fund manager, which would typically be 1.5 per cent for an equity fund.
The manager then paid the adviser a commission of 0.5% or pocketed the full 1.5% if no intermediary was involved.
In recent years, probably due to the downward pressure on fees from tracker funds, this fee has reduced to an average of around 0.75% with nothing paid to advisers, who now charge clients directly.
However, the manager’s fee is not the only fee paid by the fund - custody fees and legal fees are also paid.
They have always been there but were not always reported.
Initially this figure was known as the total expense ratio, but to confuse matters it is now called the ongoing charges figure.
This normally adds between 0.01% and 0.15% to the cost of a fund and, as these costs tend to be fixed, the larger the fund the lower the cost.
The Financial Conduct Authority recently introduced a rule stipulating that managers have to disclose the transaction charges they incur.
Previously these were not disclosed as they are hard to predict and calculate since managers do not know if they will need to trade a lot or a little.
However, transaction charges do exist and therefore the regulator is making sure that managers highlight these to investors rather than let them assume there is no cost.
Another problem is that the methodology used to calculate transaction charges currently varies and may not be consistently applied across all managers and funds.
This has resulted in a wide variation in the level of fees being applied.
We have seen instances of annual charges as high as 5.15% and as low as -0.77%.
The latter figure is not a typo - based on the way the charge is calculated it is possible, under the right set of circumstances, for the fee to come out as a negative figure.
Included in the transaction charge are unavoidable stamp duty of 0.5% on purchases, stockbroker commissions and, most confusingly, the price movement of the traded investments, known as slippage costs.
This is distorting the picture and can lead to reported negative costs. For example, where a manager decides to sell an investment at one price but the price has risen by the time the trade is actually made, leading to a trading profit that shows as a negative cost.
While the short-term movement in the underlying investments may be random, making it difficult for a manager to profit from this strategy, it appears to favour funds that are shrinking and disadvantage growing funds.
It also favours certain types of transactions.
If an IPO of shares is taken up, for example, it would avoid stamp duty and broker commission, and as initial offers are often made at a discount a likely profit/negative transaction cost would ensue.
In addition to transaction charges there are also incidental charges. In my experience the main figures appearing here are performance fees.
These can be high but of course the managers will have had to outperform significantly for these to apply so investors should not be overly concerned. Again, these will vary from year to year.
There is a well-worn phrase in investment: “past performance is not a guide to future performance”.
Now, in the effort to be more transparent, perhaps an additional phrase should be coined: “past fees are not a guide to future fees”.
David Thomson is chief investment officer at VWM Wealth.
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