What are fund charges and are they limiting your returns?
What are fund charges and are they limiting your returns?
When making investments, it’s important to not only consider the potential returns you may see but crucially the fund charges required in making those returns.
What are fund charges?
There are costs associated with most investments, particularly when there are people behind the scenes, managing the investment. For example, with an investment fund, your money is pooled with that of other investors and a fund management team then buys, sells, monitors, reports on, researches, markets and administers the pool of investments in accordance with the fund’s stated aims; which could be anything from high-risk international growth to tracking the FTSE100. All these activities carry a cost and, along with a profit margin, are clawed back from the investors in one way or another, although it’s fairly commonplace for these charges to be deducted from your investment funds, so you won’t actually be billed for them directly.
Many funds charge what’s known as an expense ratio, which is expressed as a percentage of your overall holding. So, if your investment holding in a fund was £350,000 and the expense ratio was 1%, your annual charge would be £3,500. The expense ratio is commonly referred to as the Total Expense Ratio (TER) to demonstrate the full set of investment charges associated with that investment.
Why are fund charges important?
Fund charges are important because they are not normally determined by performance and will still be charged, even if the fund makes a loss. Equally, many of the more expensive funds typically involve more active trading and aim to give higher than average returns to justify those higher charges. However, if a fund’s expense ratio is 1.75% and the fund’s return is 9%, your actual return (or ‘net return’) on your money is really only 7.25% and once you factor in inflation (resulting in the ‘real return’), which is over 6% at present, you need to be very careful as the charges could be the difference between your money growing above inflation or falling behind and diminishing in value. In this example, the real net return after charges and inflation is 9% minus 1.75% minus 6% = 1.25%. This does not take into account tax either, which may or may not be due depending on the type of investment wrapper the fund is held in. However, bear in mind this is still much more than what can be achieved as a real return on a savings account at present!
The question you have to ask yourself when it comes to investment charges is whether or not the additional risk is worth the additional charges as just with compound interest, even a tiny increase in the TER, can have a serious impact on your returns over time.
Another issue to be aware of is how your mind reacts to what may initially appear as an inconsequential charge. We would all probably think that a mortgage deal of 1.5% was incredible value, which it is, but when it comes to fund charges, we believe 1.5% is actually on the high side. We’ll compare a couple of examples below:
Your investment holding is worth £350,000 and you achieve a gross return of 8% each year with a 0.5% charge. At the end of 25 years, your holding could be worth about £2.1 million.
Your investment holding is worth £350,000 and you achieve a gross return of 8% each year with a 1.5% charge. At the end of 25 years, your holding could be worth about £1.6 million.
In this case, over 25 years, what seemed like an insignificant figure of an additional 1% in charges actually ended up costing you upwards of £500,000. These examples do not take into account inflation or tax.
Why do some funds charge more?
Often the main reason for some funds charging more than others comes down to whether or not the fund is actively managed or passively managed. Active funds may have superstar fund managers (with salaries commensurate with this stardom) who make lots of strategic trades in an effort to outperform the indexes. They often get lots of coverage in the financial press because they have big advertising budgets and there are always stories about dramatic gains and losses (you may have heard of Neil Woodford and the Woodford Funds). Remember that past returns are not indicative of future performance.
Whereas passive fund management generally describes market and index-tracking funds that mirror the FTSE100, FTSE All-Share or S&P 500, for example. The fund managers of passive funds are rarely well known and only tend to make changes to the fund to reflect any changes in their benchmark index (such as when a company falls out of the FTSE100). By its very nature, passive management is the benchmark for the market.
Do higher-cost funds offer superior returns?
In many aspects of life, you get what you pay for. However, when it comes to investments, it’s not always the case that the higher the cost of investment, the better your return will be. In fact, it’s often the case that the reverse is true with the funds carrying the lowest charges actually performing the best over the long term. The truth is, it’s virtually impossible for someone to consistently pick the best performing assets over the long term. An important consideration when selecting a fund is to compare it against the index benchmark and its peers, but you may be hard-pushed to find any actively managed funds that consistently outperform them. Having said that, some active funds do outperform the market more often than not, and these ones may be worth the extra cost.
Some example fund returns and charges for context.
As we’ve seen, it’s important to have some context in mind for what is a high charge and what’s not. Please bear in mind though that these are only examples of the range of charges that apply to a handful of funds in the marketplace (in which there are over three and a half thousand!) and should not be taken as investment advice or personal recommendations.
Blackrock NURS II Consensus 85 Class D Accumulation (Passive) 0.21% charge, net performance for the past 5 years 29.30%.
Vanguard LifeStrategy 80% Equity A Accumulation (Passive) 0.22% charge, net performance for the past 5 years 40.35%.
Baillie Gifford Managed Class B Accumulation (Active) 0.43% charge, net performance for the past 5 years 52.34%.
BMO Managed Growth Fund Class C Accumulation (Active) 1.07% charge, net performance for the past 5 years 25.57%.
All information is correct as of end February 2022 and based on information taken from FE Analytics. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall or rise and you may get back less than you invested.
Conclusion
There are many things to consider when choosing investments and charges are just part of that picture. Your financial adviser will be able to help you select a range of investments that suit your circumstances, attitude to risk, goals and broader financial position. Nonetheless, it’s clear that although we are only talking a per cent here and there, the impact on investments over the long term could be substantial, so it pays to know exactly what you are dealing with.
What’s next?
Do you think it’s worth paying the higher charges of some managed funds? Let us know in the comments below. If you need advice on pensions and how you can invest for the future, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Well, we advise clients across the UK.
Don’t forget, this article offers information about financial planning and investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.