Ask ii: what are ongoing charges and how do investment trusts levy them?

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A reader asks: “If I invest in an investment trust and look at the cost disclosure agreements that interactive investor provides, it gives an ongoing charges figure (OCF). For Gresham Energy Storage this is 1.47% to 1.52%.

“But how will the firm receive the ongoing charges, as I do not believe it is paid out of dividend income? As investment trust share prices are set by the open market as they are traded on the stock exchange, so unlike open-ended funds or exchange-traded funds (ETFs), ongoing charges are not reflected in a daily price calculation.

“So, how are ongoing charges paid by investors in investment trusts? In general, are ongoing charges a means to explain the difference between an investment's performance and the index/sector the fund is supposed to be tracking? Rather than a visible transaction like bid/offer spreads, stamp duty or commissions. Or have I totally misunderstood ongoing charges and what they represent?”

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Sam Benstead, deputy collectives editor at interactive investor (pictured above), says: Calculating what you actually pay in investment charges can be tricky, especially with investment trusts due to their structure following different processes to open-ended funds and exchange-trade funds (ETFs).

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For investment trusts, the ongoing charges figure (previously Total Expense Ratios or TER) is a figure published annually by an investment company which shows the drag on performance caused by operational expenses, such as the management fee, accounting fees, and marketing fees. Not every cost to investors is included in the OCF, such as tax fees, trading fees and borrowing costs. The figures are updated when the trust publishes its annual financial results.

The Association of Investment Companies (AIC), the trade body for the trust industry, adds: “More specifically, the OCF is the annual percentage reduction in shareholder returns as a result of recurring operational expenses assuming markets remain static and the portfolio is not traded. Although the OCF is based on historical information, it provides shareholders with an indication of the likely level of costs that will be incurred in managing the fund in the future.”

But how are investors actually paying this fee? According to the AIC, fees are deducted from the updates to net asset value (NAV) when they are published. This is generally daily, but for trusts that own more illiquid assets such as private stocks or real estate, it may be only four times a year. This means that fees show up in the reduced NAV of an investment trust that an investor has a stake of by owning shares.

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For example, if the NAV of a trust rose 10% in a year, then the actual NAV increase would be 9% after accounting for fees of 1%.

If an investor were to trade an investment trust in between NAV updates, then they aren’t technically paying any charges through a decrease in the NAV of the trust. They will rack up broker trading and stamp duty fees, however.

The NAV and the share price are different things, but over the long term the NAV drives the share price, as premiums and discounts to NAVs are generally the result of short-term sentiment shifts. Therefore, trusts where deductions to the NAV from fees are low have an advantage over trusts where fees are higher, all things being equal.

Open-ended fund fees are simpler to understand: they deduct fees when the daily unit price is updated. Generally, the fees are taken from any income generated, but if there is not enough income to cover ongoing charges then the fund manager will take its fees out of a fund’s capital.

ETFs have a similar process and make adjustments to the net asset value of a fund on a daily basis to account for fees.

The fund charge will be displayed on the fund factsheet – a document that gives a snapshot of how the fund invests, including its top 10 holdings. The fund charge is also shown on the key investor information document, the Kiid, which provides details on the risks involved when investing in the fund. 

Fund performance figures – usually given over one, three and five years on the fund factsheet – are net of fees.