We like investment trusts - but they need to cut their fees

What's the true cost of investing? No-one really tells you.

But if you are handing over your hard-earned cash to a professional money manager, you are almost certainly paying more than you think.

The retail distribution review (RDR)- due to come into effect next year - is supposed to make investment charges a lot clearer for people. But the fund management industry still seems a long way from doing this.

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Take a typical unit trust. The annual management fee paid by the investor is usually 1.5%. That's already too much given that we are living in a world of low and rapidly-changing returns from the stock market.

Yet the truth is that people actually pay more than this.

Total expense ratios (TERs) do not tell the whole story

The TER - sometimes referred to as ongoing charges - are supposed to give a clearer picture on costs. It includes things such as the annual management fee, administrative costs, audit and legal fees. These costs are added together and divided by the average net assets of the fund to get the TER.

But the TER ignores significant items such as the cost of buying and selling shares. The commissions paid by fund managers to brokers for doing this can add up, particularly if the fund trades a lot.

Other costs such as the bid-offer spread (the difference between the buying and selling price of shares), performance fees, interest costs and tax are also ignored. All of these costs reduce the value of your investment in the fund. So it's not unreasonable to want to be told how much someone is paying on your behalf.

The good news is that a lot of this information is actually out there. You just have to look for it. You can find most of it in the fund's annual report.

In May this year, the Investment Management Association (IMA) looked at the effect of transaction costs on the total costs of unit trusts. For the top 15 largest active UK funds, transaction costs (commissions and taxes) added 0.38% to the total cost of the fund. For a FTSE 100 tracker, the increase was only 0.09%.

So for a unit trust with an annual management charge of 1.5% and a TER of 1.7%, a truer cost is around 2.08%. Performance fees and exit charges on some funds would add on more cost.

Investment trusts are not as cheap as claimed

The high costs of unit trusts put many people off investing in them. But what about investment trusts? We like investment trusts here at MoneyWeek, but we reckon they need to be more transparent too.

The main reason we like investment trusts is that don't pay commissions to financial advisors or fund supermarkets. If you look at the biggest investment trusts in the FTSE 250 they have an average TER of 0.94%. And unlike unit trusts, investment trusts explicitly charge all the costs of share dealing and include it in their TERs.

But unfortunately they ignore other significant costs.

This is because most investment trusts borrow money (known as leverage) to invest on top of the money they get from shareholders. If you add on the interest costs on the borrowings and tax on fund performance to other costs, the average total cost of the big investment trusts is 1.71%.

We have calculated the true TER for each investment trust in the list below by using the information from their annual reports as follows (the example is from the Witan Investment Trust, but we've used a similar method for each):

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This cost of leverage is very significant and makes you ask whether investment trusts are really that good a deal for investors. For instance, a trust with lots of borrowings will lose more money than one without in a falling market. Conversely, they will make more in a rising market. But this makes them quite risky.

That said, buying a good unleveraged trust such as Personal Assets Trust still looks sensible from a cost and risk point of view.

Will unit trusts be cheaper than investment trusts post-RDR?

The reason why investment trust managers should be urgently looking at their fees can be summed up in one acronym RDR.

With unit trusts unable to pay commission on new unit sales - and possibly a ban on platform charges - the total cost of a unit trust could fall by 0.75% (0.5% in trail commission and 0.25% platform charge).

This would make some of them cheaper than investment trusts. So it looks like boards of investment trusts have some decisions to make if they hope to attract more business post-RDR. They may have to reduce their borrowings and interest costs and cut their fees. Let's hope they do so.

Phil Oakley owns shares in the Personal Assets Trust and the Edinburgh Investment Trust.