COMMENT
Look Out For Hidden Charges!

Most UK investors who choose to invest in shares do so through a 'collective' investment. In other words, they hand over their money to a fund manager, who then pools together contributions and decides which shares to buy and sell.

Here at the Fool, we're not big fans of these so-called actively managed funds, for two reasons. Firstly, despite being managed by highly paid, highly qualified investment experts, most funds don't beat the market in the long term. Indeed, more than four out of five funds under-perform their benchmark index over a twenty-year period.

The second problem is that investors pay through the nose for this under-performance. No, really, I'm serious! It's what I call the 'Ferrari factor' – investors have to pay hefty fees to support the expensive tastes of fund managers and their employers' profit margins. However, you need to look beyond the advertised annual management charge which all funds must quote, because other hidden charges can bump this up dramatically.

Most actively managed funds charge an upfront or initial fee of, say, 5% of your investment, plus an annual management charge (AMC) of, typically, 1.5% a year. However, a recent survey by independent financial adviser Chartwell showed that, for many funds, AMCs are just the tip of the iceberg.

Chartwell researched hundreds of funds in order to find out their total annual costs and charges, known as the Total Expense Ratio (TER). This more accurately reflects the 'true' charge that investors face when investing in a fund. However, fund providers are not required to display their TER, only their AMC, which I think is absurd and misleading.

The TER includes the AMC, plus other charges for administration, audit and custodian fees. In some cases, these additional fees can be as large as the AMC itself! Indeed, Chartwell's research revealed that funds in the UK All Companies sector that have an AMC of 1.5% can have a TER as low as 1.5% and as high as 3.22% - more than double the AMC!

For the record, the fund with the lowest extra costs on top of its AMC is the SG UK Specialist 350, and the villain of the piece is Invesco Perpetual UK Recovery fund. Thus, if both funds have similar performance, the SG fund will produce far higher returns to investors after deducting all charges. So, don't be fooled by the AMC – always ask to see the TER, too!

One bright spot on the horizon is the Financial Services Authority, the City regulator, has proposed that, from 2008, funds must quote their TERs in advertising and marketing material. Personally, I'd prefer to see this requirement introduced earlier, because investors are clearly being misled.

Of course, charges reduce investors' returns, which is why the Fool recommends investing in low-charging funds. Indeed, there's little evidence that high fund charges mean superior performance, and the reverse is often true. Furthermore, past performance is a poor guide to a fund's future returns, so you can't rely on history.

As it happens, choosing a low-charging fund that simply tracks a particular index is one way to avoid wasting fees on actively managed funds. Although I've never invested in any managed fund, I do have money stashed away in index trackers, which simply follow a particular market or sector up and down, with little or no human involvement.

The largest UK-based tracker comes from Fool Partner Legal & General - its UK Index Trust is available via the Fool. This fund invests over £3 billion of investors' money in the FTSE All-Share, which tracks the value of over 700 listed companies. It has no initial charge, its AMC is 0.5% a year, and other annual charges come to a mere 0.04%, making its TER just 0.54%. This is far lower than TERs for all but a few funds, and all of these low-charging funds are cash funds or other trackers.

So, don't let fund managers pull the wool over your eyes: look beyond the headline charges, and find out what lurks within the small print. Otherwise, your fund could be gobbling up far more of your money that you realise!

More: Learn more about index trackers and tax-free ISA shelters.

Cliff owns shares in Legal & General, and invests in index trackers and iFTSE 100 shares, an Exchange Traded Fund which tracks the FTSE 100 index.