The true cost of investing is higher than you might think

If you’re still thinking of where to put this year’s Isa allowance – today’s the last day to use it or lose it – or next year’s, there’s no shortage of advice out there.

But have you thought about how much it’s going to cost you? Given that costs are the one thing you have any real control over, it’s one of the most important things to consider. But like many things in the world of financial services, it’s often not very clear.

So I decided to do some digging. The results may surprise you…

Official measures of investing costs don’t tell the whole story

Let’s say you decide to put some of your money into the UK stock market. Rather than pick your own stocks, you decide to spread your risk by buying a fund.

You can invest with a professional ‘active’ fund manager who will try to beat the market. In return for this, you will pay a fee. Or you can go for a ‘passive’ fund that simply aims to track the market. It won’t beat it, but you don’t have to pay as much.

A key part of making this decision is knowing how much extra the active manager will cost you. After all, the active manager has to make back this cost, as well as beat the market, to give you a better result than the passive fund.

If you pick up any fund factsheet, it will show a total expense ratio (TER) or an ongoing charges figure (OCF). This includes the fees paid to the manager to run the fund, along with costs such as administration, audit and custody fees.

The trouble is that, while TERs are simple in theory, the truth is that in lots of cases you pay much more.

The true cost of active management

Let’s start by looking at unit trusts and OEICs (open-ended investment companies). Before the Retail Distribution Review (RDR) kicked in this year, the TER on a typical UK managed equity unit trusts or OEIC was around 1.7%.

Of this, the fund manager pocketed 0.75%. The financial adviser (or whoever you bought the fund from) got 0.5% in commission. Another 0.25% went to the platform provider (the likes of Hargreaves Lansdown, TD Direct, Bestinvest etc). Other costs (such as administration) came in at around 0.2%.

The RDR has since banned the payment of commissions from fund providers to financial advisers. So what’s changed?

Platform providers can still get commission and are still selling many funds with standard TERs of 1.7%. If you are lucky they might give you some of the commission back – after all, it is your money.

But now there are also lots of ‘clean funds’ that don’t pay commission at all. Of course, the fund manager hasn’t taken a pay cut and still gets 0.75%. But including administration costs, this means a typical TER will be around 0.95%.

But you are still paying a lot more than this. The table below shows the costs of investing in UK equities via various different routes. The top of the table shows the costs that are included in the TER, while the bottom shows the ‘hidden costs’.

Fund/costs Managed fund (unit trust/OEIC) Index tracker Investment trust FTSE 100 ETF
Management charge 0.75% 0.3% 1% 0.35%
Other expenses 0.2% 0 0 0
TER 0.95% 0.3% 1% 0.35%
Hidden costs not disclosed in TER
Commissions/tax 0.38% 0.1% 0.38% 0.1%
Interest 0 0 0.45%  
Bid-offer spread 0 0 0.25% 0.2%
Total costs 1.33% 0.4% 2.08% 0.65%

As you can see, one big cost of unit trusts that is not clearly disclosed in the TER, is the cost of commissions and stamp duty on buying and selling shares. These can, and do, add up.

This is especially true of active funds, where managers frequently buy and sell in the quest to find the next winning stock. Last year, the Investment Management Association (IMA) found that buying and selling by active fund managers added 0.38% to the annual cost of their funds. Tracker funds, which trade a lot less, only incurred extra costs of 0.1%.

Investment trusts – more expensive than you might think

What about investment trusts? There is a common belief that they are cheaper than OEICs because they haven’t had to pay commissions. But now that ‘clean’ funds for OEICs are increasingly available, this may no longer be true in many cases.

Buying unit trusts or OEICs from a broker platform is usually free (though this may change, as we’ll see below). But because investment trusts are bought like shares, you have to pay commissions to a stockbroker.

There is also usually a gap between the buying and selling price (known as the bid-offer spread). Spreads vary, but a figure of 0.25% is not uncommon. So this is an extra cost of investing that you need to take into account.

The other ‘hidden’ cost of an investment trust is the interest cost on borrowed money, which is often used to juice up (known as gearing) shareholder returns in rising markets.

Is it fair to include this as a cost of investing? I think so. After all, gearing works both ways. It amplifies returns when markets are going up, but it also exacerbates losses when they are falling.

Of course, you might argue that the extra gains that carefully managed gearing can deliver in a rising market offset the cost of borrowing. And evidence does suggest that over time, investment trusts have delivered better returns than their unit trust counterparts in most areas.

But the fact of the matter is that the cost of borrowing is a cost of investing that has to be paid just like a management fee, and therefore has to be justified by performance. That makes geared investment trusts look like a very expensive way to invest. An investment trust using 15% net gearing (debt as a percentage of shareholders’ funds) borrowed at 4%, would be adding 0.45% to the cost of the trust after tax relief.

Passive funds are far cheaper than active funds – but watch out for platform fees

Tracker funds and exchange-traded funds (ETFs) are by far the cheapest way to invest. They don’t employ expensive managers and don’t trade a lot. ETFs can be a bit more expensive, as you have to pay stock broking commissions and a bid-offer spread.

But watch out for platform fees. Holding all your investments with one platform provider is very handy. If you’ve been using them to hold unit trusts or OEICS, your fund provider has usually paid the platform provider out of your annual fund management fee.

But this practice will probably be banned in the near future. So this means that some platform providers will start charging customers instead. This may be a fixed fee or a percentage of the value of your investments – some providers are already charging, or are planning to charge, 0.25%-0.35% on OEICs.

Others such as Hargreaves Lansdown will charge £2 per month for each tracker fund held on their platform. Investment trusts and ETFs are usually free. So it’s worth shopping around, depending on what you plan to invest in.

What should you do?

In the long-run costs can blow a big hole in your savings pot. On the active management side, the RDR has made the choice between a unit trust or investment trust less straightforward. Whichever you choose, the point is that you have to make sure that your manager is worth the extra cost. Some are but many are not. My colleague Tim Bennett recently looked at how to choose between active fund managers

If you want to go down the low cost, tracker fund route then index funds look the best bet, especially if you are investing small regular sums. However, ETFs are better suited to investors who want to build cheap portfolios that cover a wide range of assets. I’ll be looking at how to do this in more detail in the very near future.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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5 Responses

  1. 05/04/2013, uncommercial wrote

    It’s a good thing to review investment costs, as stated they have a big influence on overall returns.

    I don’t think, though, that it makes sense to compare OEICs and Investment Trusts in such crude terms.

    It’s frequently possible to buy Investment Trusts at a discount to NAV which means you stand to get more return for the same money. Likewise, it makes no sense to add interest on gearing unless you also include an estimate of the extra returns from the shares bought with the borrowed money.

    Trading costs are likely to vary widely across different funds/trusts, and investment trusts dealing in illiquid investments (such as direct property) are likely to reduce their costs relative to OEICs by not being forced to cope with inflows and outflows of money – probably a factor in the outperformance of trusts that mirror OEICs.

  2. 05/04/2013, Trailfinder wrote

    I really question your inclusion of interest in the cost of investing via investment trusts. The use of gearing gives you a return on investing money which you do not yourself have – for better or worse.

    Also a question – if holding an OEIC can you gain/lose out if the fund moves between a bid/offer basis of valuation?

  3. 06/04/2013, EJB wrote

    The bid offer spread is a one-off cost, not an annual charge. The annualised cost of the spread will be less and less for every year of the holding. Very obviously, it doesn’t belong in the total costs figure of the table above.

  4. 06/04/2013, David Hearne wrote

    Great article Phil

    EJB you’re right about bid/offer spread being a one time event if buying Investment Trusts. However what isn’t mentioned is impact of bid/offer spread on the portfolio activity, which has a greater impact on active funds. Phil quotes the IMA estimates for tax and dealing but not impact of bid/offer spread.

    Portfolio Turnover Rate is key, fund managers produce this information, but it can be hard to source. Any fund with 100% turnover has 0.5% tax costs (stamp duty) added before getting to dealing and spread costs.

    Finally, there are alternatives to trackers that take a low cost passive approach but which aren’t constrained to following an index.

  5. 08/04/2013, David A wrote

    You are confusing. For months Money Week has been extolling the virtues of Investment Trusts as better and lower cost than OEICs. Now you say they are more expensive! Have you changed your collective minds? What is your current recommendation. Is Money Week issue 593 now out of date?

Commenting on this article closed

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