“Compound interest is the 8th wonder of the world”, according to Albert Einstein. Over the long-term, investment returns compound and you earn interest on interest. For example, if you invest £1,000 at a 5% annual interest rate, you would earn £50 in the first year. Then in the second year, you would earn interest on £1,050, resulting in a total of £1,102.50 after two years. This process allows your money to grow exponentially over time.
But it’s important to remember that the decision to invest comes with fees, and those fees can impact your investment returns. To reap the full benefits of investing, it’s therefore essential to understand the charges you are paying on your investments. Not all fees are shown transparently or are easy to understand. Below, we break down the fees you might be paying in a typical fund.
1. Entry fee
The first fee you might face is an entry fee (and/or an exit fee when you eventually decide to sell your investments). This is an initial fee charged by a fund and is deducted before you invest to cover the costs associated with setting up your investment, such as the expertise of financial advisors, brokers, and investment firms. These fees are becoming less common but keep an eye out.
2. Total Expense Ratio (TER)
Typically, the largest fee you might face is the Total Expense Ratio (TER). This includes things like management (which is higher for active than passive – discussed further below), such as trading fees, legal fees, auditor fees, and any other operational expenses. The TER is presented as an annual % which is deducted from your capital or income and can greatly affect returns. For example, if a fund generates a return of 5% for the year but has a TER of 2%, then the gain will be slashed to 3%
3. Transaction fee
Transaction costs are a commonly misunderstood fee. This is the cost the fund incurs for actually buying and selling the underlying investments and is not captured by the TER. It can include costs such as brokerage fees, bid-ask spreads, and taxes. For example, if you buy a stock for £100 and pay a £5 commission, your total cost is £105, meaning the stock must rise above that just to break even. These costs can reduce your overall returns, especially if you trade frequently or invest in illiquid assets. This is why it’s important to understand what your underlying investments are.
4. Performance fee
Some funds may also deduct a performance fee (a common example being 10% of any outperformance of its benchmark). This fee is designed to incentivize the fund manager to do well. For example, if a £200,000 investment grows by £20,000 in one year and the manager earns £2,000 or 10% of the gain as a performance fee, the value of your investment reduces from £220,000 to £218,000. You should always check what the performance fee of a fund is and ensure you are comfortable with the rate.
5. Platform fee
A platform fee covers the cost to your provider to hold your investments. There are a wide range of platform fees. Depending on your platform, this could be flat fee structure (for example £70), or a % of assets invested (typically anywhere between 0.2% to 0.5%). The fee level will depend on the amount invested and will typically be discounted the higher you invest.
Active funds come with a higher price tag
Some fund types are more expensive than others, with active funds costing more than passive funds. That’s because you are paying a manager to beat the respective benchmark, rather than simply replicating a stock market index – as is done with a passive fund. Sometimes these active management fees aren’t justified as the manager may fail to beat the passive equivalent, or they may beat the index but through excessive risk taking rather than skill.
The main reason people pay active managers is because it requires hands-on expertise in order to respond to short-term price fluctuations in various stocks, assets and bonds. Other reasons why it can be worth paying more for active management include:
- The fund has proven long-term outperformance of its benchmark
- The market is inefficient
- The asset class is illiquid
Employing a professional investment management team can therefore help identify these areas and avoid unnecessary costs.
An added benefit of opting for an actively managed fund is that you can access institutional share classes, which come with reduced fees depending on invested assets. Institutional fee arrangements are available for passive as well as active funds.
[i] Lumin’s in-house discretionary investment team use both active and passive products across a range of investment solutions. Our portfolios are actively managed as we aim to take advantage of market opportunities. Call 03300 564 446 to find out more, or get in touch via our contact form.
This article is for general information purposes only and does not constitute financial advice or a personal recommendation. Past performance is not a reliable indicator of future results. Investments can rise or fall in value, and you may receive less than you originally invested. Tax treatment depends on individual circumstances and may change in the future.
