Rising fund fees prove costly for investors

Annual charges can wipe millions off your investment. But there are ways to pay less, says James Daley

The cost of chasing good investment returns has been slowly creeping up over the past few years, as fund managers have slowly nudged up the fees they take for managing your money.

According to new research carried out by financial consultants Defaqto, on behalf of The Independent, the average unit trust or open-ended investment company (Oeic) now charges an annual fee of 1.37 per cent – compared to an average of just 1.23 per cent at the end of the 1990s.

Worse still, since a relaxation in the regulations a couple of years ago, more funds are starting to charge performance fees, which quickly ratchet up the cost of investing. It's now all too common for new funds to levy an annual management charge (AMC) of 1.75 per cent, as well as skimming off a further 20 per cent of all returns above a certain benchmark.

New Star Asset Management's Heart of Africa fund, which was launched earlier this year, is a fund that follows just this pattern – taking an AMC of 1.75 per cent, and then 20 per cent of everything the fund makes once it has achieved 3 per cent above LIBOR (the inter-bank cash lending rate). With three-month LIBOR currently standing at just under 6 per cent, this means that once the New Star fund has returned more than 9 per cent a year, it takes £1 of every £5 it makes you. On a good year, this sends the total charges bill through the roof.

Black Rock's Absolute Alpha fund is another fund that uses a similar charging structure, while RAB Capital uses performance fees across its entire fund range.

Fraser Donaldson of Defaqto says that the argument in favour of performance fees is that they "align the goals of both client and fund manager". However, Mark Dampier, the head of research for research for Hargreaves Lansdown, the stockbroker and financial advisers, points out that managers should already be incentivised to perform well by their annual bonuses, and also by the responsibility of knowing that they're looking after millions of pounds of private investors' hard-earned savings.

"When I first started in the industry, in the early Eighties, the average management fees were around 0.75 per cent a year," he says. "Obviously, the industry's changed a lot since then, and funds are much bigger, but I do feel now you're now paying more for what you used to get for less."

For the moment, performance fees are thankfully still relatively rare in the open-ended fund universe, but even those funds which don't use performance fees are edging up their charges. According to Defaqto, some 7 per cent of funds now have an AMC of 1.75 per cent or more, compared to just 2 per cent of funds nine years ago. Similarly, 59 per cent of funds now have an AMC of between 1.5 and 1.74 per cent, compared to 50 per cent in 1999.

Worse still, the annual management fees are not all that investors have to contend with. Most fund managers will try to charge investors an upfront fee of as much as 5.5 per cent when they make their initial investment – though this can usually be avoided if you buy through a discount broker or fund supermarket. However, even the AMCs are not all that they seem.

Fund managers will also take many of their day-to-day trading costs directly out of the fund. To get an idea of how much you are really being docked each year, it's better to look for a figure called the "Total Expense Ratio" (TER), which takes into account all these additional deductions as well. In some cases, the AMC can be quite low, but the TER will be much higher. Funds of funds are the worst offenders here. For example, Skandia's Global Best Ideas fund may only have an AMC of 1.5 per cent, but it has a TER of more than 2.4 per cent. But regular funds can also have high TERs. Jupiter's Emerging European Opportunities fund, for example, which invests in Russia and Eastern Europe has an AMC of 1.5 per cent, but a TER of almost 2 per cent.

The good news is, there are still some funds with lower charges out there. For example, Aegon's UK equity fund, which has almost doubled investors' money over the past five years, has an AMC of just 1.25 per cent and a TER of 1.4 per cent. Better still is the Fidelity Moneybuilder Growth fund, which has returned over 90 per cent over the past five years and has an AMC of 1 per cent and a TER of less than 1.2 per cent. Many investment trusts are also much cheaper than Oeics and unit trusts.

If you're opting for a lower-risk, lower-return product, finding a fund that doesn't charge too much is crucial. For example, if you invested £10,000 in a fund that returned 7 per cent a year for 10 years, and charged you a 1.5 per cent AMC, you'd end up almost £900 worse off than being in a fund with the same return and a 1 per cent AMC.

Although the very best managers tend to justify their higher fees – producing returns well above their benchmark – it's still possible to pay less than the headline rate for some of the top names. For example, discount brokers such as Cavendish (www.cavendishonline.co.uk) will refund you 0.5 per cent of the AMC on most funds, taking just £10 a year for themselves. Hargreaves Lansdown (www.h-l.co.uk) will also discount up to 0.25 per cent of the AMC.

If you want to pay even less for your fund, tracker funds, which simply mirror an index, are the cheapest of the bunch. Liontrust's Top 100 fund, for example, which tracks the FTSE 100 index, has an AMC of just 0.295 per cent, and a TER of just 0.36 per cent.

For more information on fund charges, visit the IMA's website (www.investmentuk.org), where the Find a Fund tool allows you to compare funds by their TER. Or for investment trusts, visit www.theaic.co.uk. Alternatively, for a look at fund performance, visit www.trustnet.com.