Personal finance: Always count the costs

Don't just look at returns on your investment, check the costs, too - you could be shocked; The longer you hold your fund, the bigger impact costs can make
Like many investors, it has taken me longer than it should have done to arrive at the realisation that costs are such a major ingredient of long-term investment performance.

Particularly with shares, it is easy to spend too much time looking at the return side of the equation and not enough at the cost element. Whether you are investing directly yourself, or through a fund, the message is the same. Costs can seriously damage your wealth.

Of course in a bull market, like the one we have enjoyed for many years now, many investors have been able to ignore costs because the overall performance of their investments has been so good. If you are making 15 per cent a year tax-free through a PEP, why bother whether you are paying 1 per cent, 2 per cent or 3 per cent to the company which is looking after your money? Many fund managers have grown fat on the back of their investors' seeming indifference to costs.

Now that inflation and interest rates have fallen so sharply, however, nominal returns from all types of investment must come down too. With inflation at, say, 2 per cent, and a long term real return on equities of around 6-7 per cent, even if you are still a long term bull of the equity market, only the foolish will count on shares producing long term returns much above 9 per cent in nominal terms.

With that kind of return, it obviously starts to make a lot more difference whether the cost of your equity unit trust, for example, is 1 per cent or 3 per cent per annum. There is no point in giving back a third of your potential annual return unless you are absolutely convinced that your fund manager can make up the difference in superior performance. In practice, a 3 per cent a year cost burden is an awful handicap for even a brilliant equity fund manager to make up - and 2 per cent a year is almost as stiff a hurdle to overcome.

But how do you find out what the cost of your managed funds are? The answer is: you can't. Fund managers will happily tell you what their annual management fee for running the fund is. But that figure is not the end of the story. There are a whole range of other costs items (such as audit, custody, and administration costs) which the fund management company will deduct from any money you invest with them.

These costs can be highly significant, and can add anything from 10 per cent to 50 per cent to the annual cost of your fund. In the United States, total expense ratios (or TERs) for mutual funds are widely collected and publicised. But in this country, the amazing thing is that, although the unit trust business is now more than 60 years old, as far as is known nobody has ever thought it worthwhile to collect and analyse total expense ratios.

Now, at last, someone is trying to provide commercially what you would have thought would already be an essential service to investors. A consultancy firm called Fitzrovia International, which has been compiling TERs for offshore funds for the last five years, has recently published the first edition of what it hopes will be regular quarterly surveys of TERs for UK-based funds. While the study is aimed at professionals, and priced above the average investor, the firm hopes to publish a retail version in due course, which will be welcome.

Having seen the first report in the series, I can say that it makes very interesting reading. Some of the findings are as you would expect: index funds are generally cheaper than actively managed funds (by nearly 0.5 per cent per annum on average). Funds that invest overseas are generally more expensive those which confine their investment to the UK.

But what emerges very clearly from the consultants' detective work is the huge difference there is between the costs charged by different providers, much of which appears to be unjustified by performance. For UK equity funds, for example, even eliminating one or two obvious non-profit outliers, TERs range from 0.45 per cent per annum to 3.67 per cent per annum. In fact, quite a large number of well-known fund managers are routinely charging their clients more than twice the average fees of their competitors.

This disparity may be only a reflection of a fund manager's exceptional record or marketing skill. There is no law which says that the most successful fund managers (such as Jupiter and Perpetual) should not be allowed to profit from their skill in having compiled a good track record.

But, as usual in these cases, it is the many indifferent fund managers in the middle of the pack who seem to be getting away with more than they should if the market were genuinely competitive, and consumers more aware of the costs they are paying. Banks and insurance companies generally come out worse than specialist fund managers.

The key message is that the longer you intend to hold your fund, the bigger an impact costs make to its performance. The table below, for example, shows the difference it can make if you put pounds 5,000 a year into a UK tax- free equity fund with a low TER (0.85 per cent) compared to one with one of the highest (2 per cent plus). Assume a 9 per cent growth rate (see above), run the numbers and what you find is really quite frightening.

Over 10 years, the burden of these additional costs will cut the value of your fund by pounds 5,000, assuming identical performance in all other respects.

That equates to 6 per cent of your fund and 10 per cent of the total amount you have invested at that point. Over 25 years, the amount you will have "lost" through higher charges is pounds 65,000 - the burden of extra costs has eaten up pounds 1 of every pounds 6 your fund by then should be worth, and over half your total investment has gone in paying these costs!

If the high-cost fund were a racehorse, nobody would think of racing it with such a handicap in place - but then this is fund management where different rules seem to apply.