How to avoid extortionate funds fees

The City likes to boast of how competitive it is. But if that's the case, why do British investors end up paying so much more than their US counterparts for managed funds? The average total expense ratio (TER), which takes into account everything from management expenses to trading fees, is 1.66% in the UK compared to 1.32% in the US, according to Lipper, a fund research firm. So why the added expense?

First off, fund managers in the UK and Europe tend to charge a flat fee, even if the amount of money under management rises. In the US, managers use a sliding scale for fees, in which charges fall as assets rise. Our fund managers are under less scrutiny too. Lipper notes that US funds are subject to greater oversight from independent directors, which further contributes to low fees.

But the key factor accounting for the difference is in the way funds are distributed, says Philip Coggan of the Buttonwood column in The Economist. The US has made a big effort to force fund managers to advertise their expenses, and 74% of investors there say they consider this a factor when investing. By contrast, 53% of funds in the UK are sold via an independent financial adviser (IFA), who normally gets commission via a trailing fee (kickback) of about 0.5% a year, a cost often passed on to the client. The Financial Services Authority's retail distribution review will seek to end commission but not until 2012.

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So for now, investors will have to cut costs themselves, by buying cheap exchange-traded funds (ETFs) or trackers. Say you invested £10,000 in a fund with a TER of 1.66%; or put it in a tracker charging 0.3% instead. Assuming an annual return of 5%, over 30 years you'd have £14,610 less if you invested in the managed fund: £26,795 as opposed to £41,405.

The entrance of tracker pioneer Vanguard into the UK market has seen the tracker TERs fall. HSBC, for example, has cut the annual management charge on its FTSE All-Tracker from 0.5% to 0.25%, leaving a TER of 0.27%. Vanguard's range, which includes European, Japanese and emerging-market trackers, have TERs ranging from 0.2% to 0.55%. The minimum investment is £100,000, but if you buy through a platform such as Alliance Trust, which charges £12.50 a trade, you can avoid this.