Fund charges: the only thing investors can control and why they matter

Differences in what you pay to own your funds can make a massive difference to your returns.

Whether you choose to invest in funds, investment trusts or exchange-traded funds (ETFs) a desired level of investment return over a specific time period cannot be guaranteed in advance.

However, one thing that investors can control is costs, which (as they are percentage based for funds) become bigger over time as your investments (hopefully) grow. Such fees are charged yearly come rain or shine – whether or not the fund manager has done a good job.

Whether you are putting money away for retirement – in a workplace pension or a self-invested personal pension (SIPP) - or investing for a specific goal in an ISA, fund charges matter because they can make a massive difference to your returns.

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Default funds

Most pension savers choose not to pick where to invest their pension. Instead, they stick with their employer’s default fund, even when it is perhaps not the most suitable option for them. This is mainly down to disinterest in pensions, which are perceived to be both boring and complicated.

The default fund tends to be some form of balanced multi-asset fund. It is selected by the pension provider to cater for a wide range of pension investors. Such funds can be selected as a relatively 'safe’ choice. The irony, though, is that while such a fund is unlikely to fall like a stone over a short time period when stock markets fall sharply, over the longer term the way such funds invest risks being a missed opportunity.  

A balanced fund will typically have 40% to 60% in global shares, but those with a 30- to 40-year time horizon can afford to be more adventurous. As history shows, for such a long timespan, short-term stock market dips end up being a mere footnote in the grand scheme of things. The latest Barclays Equity Gilt Study shows that over the past 50 years UK equities have averaged returns (after inflation) of 5.3% a year. 

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Default funds have a charge cap of 0.75%. Many active funds charge more than this upper limit, while many passive funds are cheaper.

Active funds are more expensive

When it comes to fund charges, here's the state of play: actively managed funds and investment trusts tend to have a yearly ongoing charge figure (OCF) in the range of 0.7% to 1%. Such funds are attempting to beat a comparable stock market – such as the FTSE All Share Index for funds that buy UK shares. However, there is no guarantee an active fund will outperform – the majority fail over the long term.  

Passive funds – index funds or exchange-traded funds (ETF) – typically cost less than 0.25%. If the passive product is tracking the US or UK market, fees tend to be less than 0.1%. Such funds aim to replicate the performance of a stock market. Given there’s a fee, the passive fund will, in the majority of cases, underperform the stock market very slightly. There is the occasional quirk when a passive fund outperforms – as some partially rather than fully replicate a stock market.

The fund charge will be displayed on the fund factsheet – a document which 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. 

Value for money

Whether the fund charge is low or high what matters is the end result. If you hold active funds and they deliver market-beating returns – then paying more in fees has been worth it. The risk, however, is that those higher charges are not justified, and that instead investors would have been better off ‘buying the market’ through index funds and ETFs.

The trouble with active funds is that outperformance cannot be guaranteed in advance; investors are buying in the hope that the fund manager will deliver value.

Here’s an example that shows how a premium fund fee that isn’t backed up with premium performance can leave investors worse off. The figures below are sourced from a fund fees calculator on Candid Money, a financial adviser. Let’s say your overall pension contribution (including employer contribution and tax relief) is £500 a month over 30 years. The fund, which is actively managed and invests in UK shares, charges 1% a year. The investment return per year is 4%. The investor will pocket £290,080, with £53,675 already sliced off as the fund fee. 

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Unfortunately, the active fund failed to beat the stock market over the 30-year period. Instead, the FTSE All Share Index averaged 5% a year. An index fund or ETF that tracks this index and charges 0.25% (it could have been lower if a cheaper fund was chosen), will have received £17,656 in fund fees. Overall, the investor will have seen their pot grow to £391,688.

If this same index fund or ETF returned 4% a year on average over 30 years the investor would still receive £329,308 – nearly £40,000 better off than the active fund, simply because it has a lower percentage charge.

For this example, due to the 1% charge, the active fund would need to deliver a yearly return of at least 5.8% to generate more than the £391,688 achieved by a passive fund returning 5% a year for a fee of 0.25%.  

Other charges you pay

The reality is that fund fees are higher than the figures stated by fund providers, as some costs are not included in the ongoing charges figure. The main one is trading costs, which are incurred when the fund manager buys or sells shares.

For those that levy them there’s also performance fees. There’s been plenty of debate over the years on whether such performance fees are a force for good or evil. On the one hand an argument can be made that the annual fee should be sufficient incentive for a fund manager to beat the stock market. Conversely, supporters of performance fees point out that they can help align the fund manager and investors’ interests by rewarding superior performance.