HOW DO INVESTMENT CHARGES WORK?

This is a regular question for us, because investment charges can be confusing. This article explains how investment charges work, and why this is important to understand.

Key points

  • Why are investment charges important?
  • How investment charges typically work
  • How investment charges work when you involve a financial adviser
  • Ways to reduce investment charges
  • Where to find investment charge information
  • Download our free investment checklist

Why are investment charges important?

Investment charges are important because they act as a drag on your investment returns. Suppose your investment returns 8% in one year, but you are charged 2%, the net return will be something like 6%. This means that you should pay close attention to the charges of your investment since they can seriously reduce your investment growth over time.

The issue of charges can be complicated since it could be argued that the overall growth of your investments is more important. For example, say you bought a lower-cost investment, costing 1% per year. This would mean a smaller drag on your investment returns, and in theory should mean a greater net return. To use the example above, if the return was 8% before charges, the net return would be 7% after charges. Therefore, it makes sense to reduce charges where you can.

Of course, having a lower-cost investment does not necessarily mean you will achieve higher net returns. If the higher-cost investment achieved 10% return before charges, but charged you 2%, you would end up with 8% net return. if the lower-cost investment achieved 8% return before charges, but charged you 1%, you would end up with a net return of 7%.

As you can see it is not a straightforward issue, but is one to which you should pay close attention.

How do investment charges work with ‘standard’ investments?

This article has to generalise by necessity, but this will give you an idea of the type of charges you would pay for buying retail investments such as OEICs and unit trusts. The charges set out below assume you buy your investment directly with the investment provider. We have compared this retail approach to one assuming you use a financial adviser in the next section.

Initial charges

Most retail OEIC investments charge up to 5% of the initial capital. These charges vary, and are gradually reducing due to competition. Some investment funds have no initial charges. To put this into context, if you invested £100,000 the initial charge could be as high as £5,000. in this scenario, £95,000 would be invested. The initial charge could also apply to regular savings. For every £100 you save, £5 could go in charges, leaving £95 to be invested. This initial fee is calculated differently for unit trusts, but it effectively works out as a charge of up to 5% of your initial investment.

Annual charges

Annual Management charge

Investment funds typically charge an Annual Management Charge (AMC). This pays for the management of your investments as well as other annual costs. For a share-based investment fund the typical retail Annual Management Charge is 1.5% of the total investments per year. Some types of investment funds,  such as corporate bonds, have typically lower Annual Management Charges. Some, more complex investments have even greater Annual Management Charges.

Other annual charges

Unfortunately, the Annual Management Charge is not the end of the story for annual investment charges. You also need to look out for additional charges. These can include dealing costs, trustee fees and taxes paid by the investment managers. These tend to be quoted separately to the Annual Management Charge of the fund, and might add an additional 0.25% per year to the Annual Management Charge. In general, the more the fund manager buys and sells investments, the greater these transaction costs can be. A study by the financial regulator estimated that trades made by fund managers account for additional fees which are very difficult to track.

Total Expense Ratio

An easier way for you to judge the overall annual charges of your investment is to look at the Total Expense Ratio (TER). This must be quoted by the fund manager. It will include the Annual Management Charge plus typical additional expenses. This might be disclosed as “Ongoing charges” on a factsheet.

Performance fees

Some investments have an additional performance fee which is payable if the investment beats a certain level of returns, perhaps beating an index. These can be as high as 20% of the excess returns above a certain level. The argument is that the fund manager has done so well in that year that they can justify this additional charge.

Exit charges

Some investments have a charge for exiting the fund, perhaps before a certain date. These are typically applied to older investments and are rare with most collective investments such as OEICs and unit trusts. Just be careful to check these do not apply to you before you sell an investment.

How does having a financial adviser alter your investment charges?

Your financial adviser will have a keen eye on the charges of your investments since they will be well aware of the issues raised above.  Here are some of the typical charges you would incur for investing via a financial adviser, and how they might differ from a typical retail investment.

Investment wrapper

As financial advisers we typically recommend that clients invest via an investment wrapper. These are administration platforms which allow us to buy and sell investments for you, and to make trades easily. They have a number of benefits:

  • Simpler administration
    The idea of these platforms is that they allow you to keep all of your investments in one place, thus making your administration burden much lower. This convenience helps you to keep track of your investments much more easily.
  • Transparent charges
    Most investment wrappers allow you to clearly see the charges that you pay. This transparency is generally having a downward pressure on costs as platforms complete to win and retain business.
  • Access to a vast array of investments
    Investment platforms allow you to buy  from a massive array of investments. Instead of choosing from 50 funds offered by one investment provider, you can instead choose from thousands. in some cases, the range of investments is unlimited. You can also access institutional investments, not typically open to retail investments. These can have lower charges and better fund performance.
  • Access to different tax wrappers under one platform
    You can bring together different types of tax wrappers such as investment accounts, ISAs and pensions. This means you can move money between your wrappers when it makes sense to do this. You can also follow a similar investment strategy across all of your investment wrappers.
  • Buying power
    These investment platforms have billions invested on them, which allows the platforms to reach deals with the investment companies to offer their investment funds at a discount. This can greatly reduce your costs. The buying power of the investment platforms typically reduces the Annual Management Charge cost of an investment by half – from 1.5% to 0.75% per year.

Investment wrapper charges

  • Platform charge
    Think of the investment wrapper as an administration platform. Charges vary, but would typically range between 0.25% and 0.5% of the investments held per year.
  • Tax wrapper charges
    Some investment wrappers have level annual costs for holding certain tax wrappers. These vary, but might be £20 to £100 per year depending on the company and wrapper used.
  • Dealing costs
    Some platforms charge dealing costs, ranging from a flat fee of say £5 per trade, to a small percentage of the value traded, say 0.2%.

Initial charges

In my experience it is rare for investments to have an initial charge when you buy them through an investment wrapper. This immediately saves you the 5% charge you might pay for buying the same investment directly with the provider.

Annual fund charges

The buying power of investment platforms means they can do deals with the investment fund managers for selling greater amounts of investments through their distribution channels. This typically reduces the Annual Management Charge by half, so from 1.5% per year to 0.75%.

If you work this out, the total charge might look like this:

Charge Retail Wrapper Saving using a wrapper
Initial charge 5% 0% -5%
Annual wrapper charge 0% 0.35% +0.35%
Annual fund charges 1.5% 0.75% -0.75%
Other annual charges 0.25% 0.25% 0%

In the example above, you would save the 5% initial charge, plus 0.4% per year in Annual Management costs.

Let’s put this into monetary terms, assuming an investment of £100,000:

Charge Retail Wrapper Saving using a wrapper
Initial charge £5,000 £0 -£5,000
Annual wrapper charge £0 £350 +£350
Annual fund charges £1,500 £750 -£750
Other annual charges £250 £250 £0

In this example, which is only a guide, we can see that by using a financial adviser you would have saved £5,000 in year one, plus £400 per year for every year you hold the investment. This is money which goes directly to greater growth in your investments.

The adviser’s charge

Of course, you will be thinking about the level of fees that financial advisers charge. This will eat into the growth of your investments, although what you should get for this is:

  • Comprehensive research
    Your financial adviser should be able to help you to choose from amongst them best investments available using a variety of research tools to analyse the market.
  • Experience and expertise
    Your financial adviser should use a combination of experience and expertise to help you to avoid costly investment mistakes.
  • Process
    Investing money is all about following a certain process to ensure that you do not miss obvious areas. Your financial adviser should help you to ensure that you have all the areas covered that you migth not think of.
  • Risk management
    A vital area in investing money is managing the risks you take. Your financial adviser should be able to help you to diversify assets, and to ensure that you take the levels of risk appropriate for your needs. They will also ensure that your investments are regularly brought back into line over time to avoid you taking a different level of risk to the one you signed up for.
  • Ongoing service
    Your financial adviser will be on call to regularly review your portfolio, and to answer questions you may have. This is probably the most important area.

What your financial adviser charges you depends on their business model. See our article on financial adviser charges, as well as our Investment Management service costs.

Ways to reduce charges

Obviously, we would recommend that you take financial advice before making any investment decisions. However, if you have the knowledge to do it yourself, you can certainly save money.

Doing it yourself

One method could be to buy investments directly. This could mean purchasing individual shares or bonds directly from the source. This way you will save on the platform charges and adviser charges mentioned above. Just be careful that you know what you are buying, and ensure that you properly diversify your assets.

Discount brokers

You can use one of the many discount brokers out there. They will usually provide you with a low-cost, advice-free option to buy pretty much any investment you could want. Check that the charges are genuinely cheaper, and again, ensure that you know what you are buying.

Investments with typically lower charges

  • Index funds
    Index funds, also known as passive or tracker funds, allow you to invest in an index such as the FTSE 100 of UK shares. There are various methods used to build these funds, but their main benefit is that they are typically much cheaper than ‘active’ investments. You might buy a share-based index fund for 0.25% Annual Management Charge rather than 0.75% Annual Management Charge with an actively managed fund. The additional charges might also be lower due to a lower turnover of assets (although this varies). The main downside to these funds is that you will always get just below the average returns of an index. It could be argued that the best actively managed funds give you a better chance to beat the index. Of course, it is very difficult to do this consistently over time.
  • Investment trusts
    Investment trusts tend to have much lower Annual Management Charges than OEICs and unit trusts. This can be a useful way of reducing your charges. The downside is that investment trusts often come with higher volatility and therefore risk than other investments.
  • Special offers
    There is now more pressure on investment providers to reduce their charges. Often they will tempt investors with reduced charges on some sort of special offer. This can often come in some sort of initial discount.

Where to find information on investment charges

Key Investor Information Documents (KIIDs)

The easiest place to look to find out the initial and regular charges under an investment fund is to look up the Key Investor Information Document. This is information which must be provided to investors, and so comes in a standard format. Details of the charges will be given as Entry charge, Exit charge, Ongoing charge (includes Annual Management Charge plus other annual expenses) and Performance fee.

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Dan Woodruff

Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.

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