If you have been invested in global markets over the last decade, you will have needed nerves of steel. During that time, investors have suffered through the worst financial crisis since the 1930s, the near collapse of the eurozone and, more recently, widespread panic-selling over a slowdown in China, and global market turbulence in the wake of the UK’s decision to ‘Brexit’ the EU.
Investors have no control over the vagaries of the market and the impact of so-called ‘black swan’ events like these, but one thing they can control is the impact of fees on their investment returns.
The key thing to understand here is the powerful effect of compounding. Compound interest is when your investment generates returns which are then reinvested and produce their own earnings, ramping up the size of your savings pot much more quickly. But compounding can also work against you if you’re paying too much in fund fees, as the cumulative effect of these charges erodes your returns over time.
Historically, fund management groups have not made it easy for investors to see exactly how much they are paying in fees and charges, or what for. But regulation has been pushing the industry towards clearer and more transparent charging structures in the last few years, and providers now have to show an ongoing charges figure (OCF) on the key investor information document (KIID) for each of their funds. The OCF includes a fund’s annual management charge and administration costs, but doesn’t include other things such as transaction costs.
‘Managing investments involves time and money and you must expect to pay reasonable charges. But fees erode your investment earnings.’ – the Money Advice Service
So how much can you expect to pay in fees and charges each year? It depends on the type of fund you hold. Charges across the industry have been trending downwards in recent years, as fund providers fight to stay competitive. On an actively managed open-ended fund, you might expect to pay an OCF of around 0.75%-1%, although fund of funds or specialist vehicles investing in illiquid assets may cost more. Providers also charge platform or account fees in addition, increasing costs even further.
Passively managed exchange-traded funds (ETFs) and index trackers aim to replicate the performance of major indices at a low cost. They have the advantage of lower transaction costs than active funds because they trade less. Their ongoing charges can be anywhere from 0.1% to 0.6% a year, and there is a race to the bottom on pricing happening between providers in this part of the market.
Some absolute return funds may also levy a performance fee of around 20% for any outperformance above a certain level, although use of these fees has been falling. A performance fee is usually a separate charge and is not included in the OCF.
There may also be an initial fee, often 5% of your initial investment, for buying into a fund, as well as exit charges for selling it, and transaction costs for the trades the fund manager makes within the portfolio.
Although the differences in the prices of these products might seem minor, they can have a huge impact on the growth of your portfolio over the long term. Let’s look at an example.
Imagine a 30-year old man has just received an inheritance and wants to put some of it to work in the market. He invests his full New ISA (NISA) allowance of £15,000 in an actively managed large-cap UK equity fund which delivers an average annual return of 6% before tax. If he leaves his lump sum to grow for the next 35 years, the pot should be worth £115,291. But the impact of fees and charges on the value of the investment is significant, even without factoring transaction costs into the equation - these costs take out a chunk worth £31,273, leaving our investor with just £84,018. The power of compounding is working in reverse here as costs chip away at the long-term returns.
If our investor puts his money into an exchange-traded fund replicating the performance of the FTSE 100, however, which has an ongoing charge of 0.1% and delivers the same annual return as the active fund, the total cost of investing is just £3,967. This means the investor’s savings pot is worth £111,324 at age 65. That’s a difference of 33%. If our investor adds some low cost funds into his pension fund as well as his NISA, he could achieve salary independence and a comfortable retirement a lot sooner than he expects.