Funds have many different charges and not all of them are that obvious.
Do you realise how many different fees apply to investment funds?
To start with there's a percentage charge called the annual management charge (AMC). There's also fees and expenses for the trustees of the fund, custodian management fees, registrar fees, audit fees and regulator fees. These are typically shown as extra expenses, but sometimes they can be included in the AMC (excluding the registrar fees).
To make it easier, funds must provide us with one figure adding these all together. This is the total expense ratio, or TER, and can be found in fund providers' literature.
The effect on your investments
In recent years, the average TER for UK funds has been around 1.6%. If you invested £100,000 and got an annual return of 8% for 30 years, you'd end up with just over £1 million. However, deduct the average TER of 1.6% and your final pot would be £640,000. That means around 40% of your gains would be eaten up by charges.
As we say here at the Fool, small differences in investment return matter. A lot.
Now add on the hidden charges
But what would happen if you paid double that in charges?
The TER excludes transaction costs arising from your fund buying and selling its underlying investments. What's more, some funds pay for special reports from brokers, and this isn't covered in the TER either. All these charges reduce the performance of your fund.
According to a recent Times article, the charges on UK funds included in the TER amount to £4.3bn per year. The same article claims that we're paying £5.8bn in 'hidden' charges, such as commission, taxes and interest on borrowings, potentially more than doubling the cost of the average fund. These extra charges could wipe out an additional 2% of your returns each year. In our 30-year example, you'd now end up with around £350,000.
Many of these charges you'd have to pay if you invested directly in shares yourself. However, one big difference is that funds tend to buy and sell their investments rather too frequently. Indeed, according to an FT piece from earlier this year, the average institutional holding period for an investment is just 9 months. That's fast and it means a lot of transaction charges.
To look at this in more detail, I examined some data for 12 Legal & General actively managed funds.
| Fund | TER | Portfolio
turnover | Max price
spread | 5-year
return |
|---|
| Pacific Growth | 1.68% | 107% | 1.64% | 77% |
| General Growth | 1.67% | 150% | 1.14% | 22% |
| European | 1.70% | 298% | 0.28% | 17% |
| UK Smaller Companies | 1.69% | 48% | 3.12% | 9% |
| Active Opportunities | 1.67% | 71% | 0.90% | 4% |
| North American | 1.68% | 145% | 0.78% | 1% |
| Global Growth | 1.71% | 210% | 0.79% | 1% |
| Equity | 1.17% | 116% | 0.90% | -5% |
| Japanese | 1.70% | 980% | 0.70% | -39% |
| Worldwide | 1.70% | 6% | 0.79% | N/A |
| Asian Income | 1.74% | N/A | 1.27% | N/A |
| UK Alpha | 1.72% | 51% | 6.20% | N/A |
Data from L&G and Citywire. In some cases, marked N/A,
there was no comparable data from the same periods.
The TERs of these funds are all very similar at around 1.7%. You can see those in my second column.
The third column shows the turnover rate of the holdings, and this varied dramatically between the funds. A 100% turnover rate means that the whole portfolio was turned over once during the period. So, the lower the number, the lower the transaction charges the fund should incur. The lowest turnover was just 6% and the highest, Japan, a massive 980%! This means this fund turned over its portfolio almost ten times in a year.
The fourth column contains the 'maximum price spread'. The price spread is the difference between the buying and selling price, as the selling price of an investment, at any given time, is always lower than the buying price. Smaller and more exotic investments tend to come with a larger, and therefore more expensive, spread. The smallest spread is a mere 0.28% but the largest a massive 6.2%.
The final column shows the investment return over five years. Again the Japan fund sticks out like a sore thumb. A tracker in the same market might have lost around 11% over the period, whereas this one lost 39%. It's massive portfolio turnover may be part of this difference.
Comparing against trackers
I also looked at 9 Legal & General index trackers. The maximum spreads were between 0.43% and 1.41% (so spreads aren't always lower for index trackers). On the other hand, the portfolio turnover figures were much lower, ranging from 0% to 18%. The average was around 13%.
The TER, portfolio turnover and price spread is information that can be found on fund providers' websites in the simplified prospectus for each fund. The FSA says this should also give a 'clear reference' to where to go to find historical TERs and portfolio turnover figures for the fund, which is useful in case it's just had a good (or bad) year. However, in this case, I was unable to find the older data.
So here you can see the double advantage trackers have over actively managed funds. Not only are their management charges significantly lower, they buy and sell investments far less frequently. This means you pay less 'hidden' transaction costs and this should help boost your overall return.
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