The hidden costs behind income funds

Been buying any funds this week? If you have I bet you've been buying income funds. After all, everyone else is. Look at the lists helpfully published by the likes of The Share Centre and you will see that they are dominated by funds that promise to deliver the kind of returns that banks no longer can.

The top funds in August? Think Newton Asian Income, Invesco Perpetual Income and Fidelity Enhanced Income.

Glance at a list of top investment trusts and you will see the same thing. The most popular ones (judged by the extent of the premium to their net asset value at which they trade) are the ones that promise the highest income. There's the much loved Edinburgh Investment Trust, trading on a premium of over 3%. There's Henderson High Income on nearly 4% and Murray Income on 3.6%.

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On the face of it this makes sense. Not only does everyone need a source of income at the moment, but history tells us very clearly that quality dividend-paying stocks consistently provide the best returns.

However, there is something that is often overlooked when it comes to income funds: the fact that the vast majority of the time a large part of the money paid out as income is not actually income. It is part of your capital being given back to you.

How does that work? In an ideal world the costs of a fund are charged to the income that fund receives.

So if a fund gets a dividend income equivalent to 4% of the value of its assets but has total expenses of 2%, its income, net of costs, will be 2%. But in order to bump up the income they can offer, a huge number of funds now take the costs out of your capital instead. So you end up with a 4% yield but 2%gone from your capital.

Numis Securities produced a report in July in which they noted (albeit in a different context) that many investment trusts are "supporting dividends" by charging costs to capital. The report came with a horribly revealing chart showing both the quoted yield on a variety of income funds and what that yield would be if the costs were charged to income.

The standout? The Edinburgh Investment Trust, which has a yield of well over 4%, but what we might call a real yield of well under 3%. Look to the unit trust sector and you will find even more funds at it. Pretty much every income fund I have ever heard of quotes yields without costs.

This is all absolutely standard stuff in the world of fund management. No one I ask about it has the faintest idea why I think it matters. But it does. Why? Several reasons. The most obvious is tax.

The tax on dividends is different (and higher for most) than the tax on capital gains, so it isn't a given that we want our capital converted to income for us. We might be better off taking the lower income and selling a few units or shares if we want more cash.

Then there is transparency. Not only do most investors have no idea this practice exists, but if funds don't all charge costs in the same way how are ordinary investors to compare them? Let's say there are two funds. They both have total expenses of 2%. But one calls itself an income fund and has a stated yield of 4%, while the other calls itself a growth fund and has one of 2%.

Which one are you going to buy? Odds are it will be the former on the basis that it comes with a better yield. However if it is charging its costs to capital rather than yield, that just isn't the case: they could both have the same real yield. It is difficult to compare funds based on yield if you don't understand how that yield is generated.

But the most important reason of all is that by turning capital into income now, you rob yourself of part of your chance to build long-term wealth. Here comes some maths: we have two identical funds. Both make total returns of 8% compound over 20 years before fees.

The first charges all of its 2% total expense ratio to income and pays a dividend of 2%. The second charges it to capital and pays 4%. The result? Add up all the dividends and capital growth over the period (the total return in both cases) and you will see that the fund that charges to income thanks to the miracle of compounding beats the fund charging to capital by more than 10% over the period.

You can quibble with the numbers of course. You may also say that this just doesn't matter. If investors make the choice to go for a high income, this is just the way it goes if the utility of the income is worth more to them now than greater wealth is later, that is their choice. That may be so.

The problem is simply that a good many investors have no idea that they are making this choice. In the search for yield, and nothing but yield, they are missing all the ways in which their yields are created and the fact that when you turn capital into income, you can pay a high and long-term penalty in terms of growth.

This article was first published in the Financial Times.