How to reduce the cost of investing

Posted by Stephen Sutherland on Sat, Apr 27, 2013 @ 01:30 PM

Reducing the cost of investingCharges and fees can seriously eat into your returns. When you fail to achieve adequate growth you run the risk of your wealth decreasing and if this happens during your retirement it can have disastrous consequences. To help increase the probability that this doesn’t happen to you, I’m now going to attempt to simplify charges and the cost of investing.

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Throughout your investment career, you have to be aware who is charging you and what the charge is for. There are many different ways that you can be charged when investing in funds and so I suggest you always ask your adviser (if you have one) and your platform provider (or broker) what they are charging you. Clarify the amount being charged, what the charge is for, how it is charged and whether it will appear on your statement.

Some fees called ‘explicit charges’ will appear on your statements, while other ‘implicit charges’ won’t, so make sure you get verification of the cost of investing in writing. I also recommend that you look at their terms and conditions to do a cross check. My guess is that what you think you are getting charged and what you are actually getting charged are two entirely different amounts. When you add up all the costs together and factor in inflation, my estimate is that you would probably need to make a return of approximately 6% per year just to break even! Shocked? Yes, I was too when I first discovered the real cost of investing. Discovering these truths reminded me of the importance of why most investors need to set their aims higher. My belief is that if investors knew the actual costs associated with investing, the majority would increase their return targets.

Charges before the Retail Distribution Review (RDR)

Many investors want to know how they’ve been charged in the past, just in case there's a discrepancy between what they were told they were going to be charged and what happened in reality. Prior to January 1st 2013, if you were investing in actively managed funds, a minimum of 1.5% was taken directly out of your investment account. This 1.5% is called the Annual Management Charge or AMC for short.

Here’s the breakdown of the 1.5% AMC and how it was distributed pre January 1st 2013:

Since January 1st 2013, the 0.5% that typically went to the adviser has been banned. This was known as ‘trail commission’. Before January 1st 2013, when you traded on a platform, if you didn’t assign a person or company as your adviser, the platform provider would by default assign themselves as your adviser and this would mean that they could pocket the 0.5% trail. As I write this in April 2013, this practice still goes on. That means in some cases the platform provider and the product provider split the 1.5% down the middle. Half the AMC would go to the fund company and the other half would go to the platform provider. 

I urge you to explore a handful of the fund supermarket’s terms and conditions, because what I found when I took a closer look was that the majority of the revenue these companies make is created from the AMC. When I started to dig, I discovered that some platform companies state in their terms and conditions that they ‘may also receive reasonable gifts from product providers’ which to me sounds a little suspicious.

The cost of investing after the RDR

Post the RDR, the majority of fund companies are still charging 0.75% to invest in their actively managed fund range even though it may appear at first glance that they have slashed their prices. New ‘unbundled’ share classes have been created to replace the old style ‘bundled’. With the bundled share class, if you peeled back the layers of the AMC, you’d see the 0.75% fund manager fee, the 0.25% platform fee and the 0.5% trail commission. With the new unbundled versions, the 0.5% trail has been stripped out and in some cases so has the 0.25% platform fee.

This is why you’ll find the majority of these new share classes priced with an AMC of 0.75%. This new share class comes with fancy names such as commission free, clean, completely clean and super clean. When you invest in these new types of share classes, the platform provider will charge you an ‘explicit’ annual platform fee which will probably be 0.25%. The key lesson here is that whether you are investing in a bundled share class or unbundled, the fund company will still be getting their 0.75% and the platform provider will still be getting their 0.25%.

3 categories of charges

Let's start to break these charges down. To keep things simple we'll divide the cost of investing into three categories:

  1. Fund charges
     
  2. Platform charges
     
  3. Advisory charges


1) Fund charges


Fund charges are also known as product charges. Fund companies charge one off fees (e.g. the initial fee) and ongoing fees (e.g. the AMC). When you invest in a fund, the fund company will always charge you an ongoing annual fee. Whether the fund company is Hargreaves Lansdown, Fidelity, Schroder, Jupiter, Invesco or any of the hundreds of other investment houses, they will all charge an annual fee. This fee is an implicit charge, meaning it's invisible and does not appear on your statement. This charge is masked from your view and is taken directly out of your investment account. 

A tiny amount will be removed from your account on an almost daily basis and it’s impossible to see or know how much has been deducted. Because it’s so small, you don’t even notice that it’s been taken. It is a strange fact and one heck of a coincidence that almost all the UK fund management companies charge exactly the same AMC for their actively managed fund range. This is typically 0.75%. I remember seeing Alan Miller from SCM Private on CNBC touching on this point and mentioning that there was an almost ‘cartel’ feel about what’s going on.

Alan said that across the pond the American fund companies have varying charges for their AMCs, but in the UK all of them charge the same. Hmm, that is interesting. The thing that really bothers me is that fund companies, platform companies and fund supermarkets have all failed to explain this invisible annual ongoing fee to people like you and me. It appears that they’ve purposely locked this secret away from the private investor community and for countless years got away with it. I learned how this covert fee was taken during my research of platforms and fund companies.

I found that on every occasion, the details about how this charge gets deducted is always in small print and usually buried deep in the companies' terms and conditions. It’s also in language that is unclear and vague. As well as being charged a 0.75% annual management charge, there are other ongoing fees to be aware of. For example, some funds with ‘absolute’ in the title operate like a hedge fund, which means they use both long and short trading strategies with the aim of making a positive return for the investor in both up and down markets. This sounds good in theory but I am yet to be compelled to invest in one.

Hedge funds charge a 20% performance fee and so do absolute return funds. Some funds without the term ‘absolute return’ in the title also charge a performance fee. There are also other ongoing fees to be aware of such as trustee fees, auditor fees, portfolio transactional costs, stamp duty reserve taxes and transfer taxes, which when bundled together can bump up the annual ongoing charge by a further 1%.

Fund companies also charge one off fees such as entry and exit fees. Entry fees are also known as initial charges and often these can be as high as 5.5%. Initial fees can often be dramatically reduced – sometimes to zero – if you buy smartly through a fund supermarket. Fund exit fees can be as high as 5% but mostly can be avoided if you invest on the right platform. 

However, you have to be careful because some funds will charge you an exit fee if you invest in it for less than 90 days. An investor who uses a stop loss strategy when investing in funds could get clobbered with a hefty exit fee should they get stopped out within the 90 day penalty period. With fund costs and charges, it’s always best to confirm what you are getting charged by checking the fund’s Key Investor Information Document (KIID).

In the second half of this 2 part blog, I’m going to look at platform charges and advisory charges and their implications for your investment account.

As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.

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Topics: Investment funds, Investment strategy, Investment charges