The Labyrinth of Fees – The Real Cost Of An Investment Portfolio

24 February 2017  |  Simon Miller
The Labyrinth of Fees – The Real Cost Of An Investment Portfolio
Initial sales charges, transaction costs, performance fees: most financial products are far too expensive.
We have calculated how much costs can reduce returns and suggest cheaper alternatives.

Do you know what the TER is? The abbreviation stands for Total Expense Ratio and is the first number you’ll be guided to when you ask what the fee is for a fund. Regulations were recently updated to require funds managers to provide their OCF (Ongoing Charges Figure) and not just the TER. This is because, despite the misleading name, the TER leaves out three other charges, namely: initial sales charges, performance fees and transaction costs. Even when looking at OCF there are actually still some additional costs that are not reported which need to be considered.

It cannot be stressed enough how fatal these fees are for a private investor. Costs are a brutal yield killer and can be the difference between a good and a bad investment. This is down to compound interest: not only do you lose the money you paid in fees, you also lose out on the potential compounded growth that would have otherwise been generated by that money.

We want to shed light on the labyrinth of fees. Here we show which costs are incurred where and how they impact the success of an investment.

1. Initial Sales Charge and Exit Fees

When you open an investment portfolio there are a couple of ways that you may face an initial charge. Some advisors charge an initial fee for their services which will be charged on the total amount you invest through them. Alternatively, you may find that, when you invest into a fund on an investment platform either advised or DIY, the fund has an initial charge taken on the amount you invest. Look out for these charges because they have a very detrimental effect on investments.

Costs are a brutal yield killer and can be the difference between a good and a bad investment.

Imagine an investor has £50,000 to invest. Assuming a six percent return over 30 years the final portfolio value would be £287,000. Now take entry fees into account. The £2,500 (five percent) the investor would have to pay initially brings the opening sum down to £47,500. A six percent return over 30 years on this reduced sum would generate a portfolio worth £270,000. What started as a cost of £2,500 actually ended up costing you £17,000.

An exit fee is charged when a client wants to withdraw their investment. These are less common in the fee schedule of most investment providers, however, they do still exist and should be avoided at all costs.

2. Management Fee

The most significant fee for investing is usually the management fee, and it forms the main component of the TER. This fee is deducted directly from your assets, diminishing your returns. Funds with the highest management fees tend to be actively managed funds with one or several fund managers in charge of delivering performance.

You would assume that with higher management fees for actively managed funds the fund manager would consistently generate above-benchmark returns. In practice that is rarely the case. In Europe, 87 percent of all actively managed equity funds are underperforming the benchmark index over 10 years. In spite of this, UK investors continue to pay somewhere between one and two percent every year for actively managed funds.

Few realise how much better off they would be if they used passive Exchange Traded Funds (ETFs) instead. They cost significantly less at somewhere between 0.1 and 0.5 percent every year and with a universe of over 1,500, you can easily find an ETF to cover your preferred asset class. Read more about ETFs in our blog post The Rise of the ETF.

You may assume that a Porsche can easily outrun a Fiat; quality and expense are two frequently associated ideas. However, the association doesn’t run true when it comes to investment management. Just because an investor has paid a particularly high management fee does not then guarantee outperformance and high fees can often leave investors disappointed. Extensive research by agencies such as Morningstar has all reached the same conclusion; that the most expensive funds often yield the worst investment results.

3. Custody Fee

The management fee does not cover the administrative costs of holding a fund. The securities must be left in a deposit account which is taken care of by a custodian who charges a custody fee. This fee is usually between 0.2-0.4 percent per year and is either included in the TER or is sometimes charged separately depending on which platform you are using to invest.

4. Other Operating Costs

There are still other costs that investors need to pay for which make up the remainder of the TER. Auditors, lawyers, advertising, marketing, annual and quarterly reports all come out of the fund’s assets. These extra costs slow down the accumulation of investor profits, as you can see from the graphic.

Small Differences in Annual Fees have a Large Impact on Performance Over Time

Small Differences in Annual Fees have a Large Impact on Performance Over Time
Past performance or future projections are not indicative of future performance.

The chart illustrates the performance of an investment of £100,000 over a 30 year time horizon and different fee levels, yielding an illustrative annual return of 6 percent before fees. The outcomes were calculated using two different rates: 1.0 and 1.85 percent per year. 1.85 percent is the average annual fee charged by a more traditional wealth manager for a managed portfolio. The value is calculated using the average TER and initial sales charge over several years.1

The 1.0 percent is the total cost ratio of Scalable Capital. It is made up of our annual fee (0.75 percent) and the average annual ETF fee (0.25 percent). The ETF fee is paid directly to the providers and not to us; we do not charge any additional costs. Scalable Capital is much kinder to long-term returns, as you can see from the chart. After 30 years the 1.0 percent portfolio has generated a staggering £93,523 more than the 1.85 percent portfolio; almost as much as the initial investment sum.

5. Trading Fees and Implicit Transaction Costs

Trading fees are often charged on a per transaction basis or on a basis point fee level depending on the size of the trade. These fees are often overlooked from the cost of managing investments as they do not fall inside the fund’s TER but instead are a charge placed by the custodian for the administration of placing trades.

In addition, the way active fund managers manage their funds can incur implicit trading costs. This is because if a fund manager trades very frequently then they are repeatedly crossing the “bid-offer spread” to buy and sell holdings for the fund. Depending on how active the manager is these costs can add up to as much as an additional 0.5 percent per year.

And what about ETFs? They are also subject to transaction costs, but ETFs are rarely actively managed so trade much less often. Transaction costs are therefore much lower.

6. Performance Fees

Over the past few years, fund houses have discovered another lucrative source of income: the performance fee. This fee is a measure of portfolio performance and is primarily used by actively managed equity and multi-asset funds. It is not included in the TER.

There are several variations of the performance fee. The fee could be triggered if the fund performs in line with its benchmark if it generates a target minimum yield, and/or if it reaches a certain target outperformance (the “High Water Mark” rule). Fund managers then typically scoop up somewhere between ten and 25 percent of profits. There are two ways of justifying these fees; firstly it’s claimed that they motivate managers to outperform, secondly it’s claimed that the fees are entirely fair given that the fund house only earns when a profit is actually generated.

However, a closer look throws this defence into considerable doubt.

  • Studies show that those funds charging performance fees do not perform any better than those that don’t. Clearly, the performance fee does not successfully motivate managers. The fee may also tempt managers to make speculative bets as they try to generate higher profits.
  • Funds that charge a performance fee do not charge lower management fees in return. Instead, they simply saddle the investor with extra costs.
  • The performance fees are asymmetric. This means that if the fund makes a loss, doesn’t hit the minimum return or underperforms the benchmark, nothing happens. The management fee does not fall, let alone is it (or previously paid performance fees) refunded to the investor. The fund house benefits from profits but the investor bears the risk of loss alone. That doesn’t seem fair.

In Conclusion

Is there any profit left at the end of this labyrinth of fees? No matter what, the investor will have had to dig deep into their pockets. “What costs nothing is worth nothing,” so goes a famous proverb. A variation of this is more accurate when it comes to investment management: "What costs a lot is worth nothing." High costs are not associated with better investment returns.

All fee-based decisions are crucial when it comes to choosing the right investment. Unlike return, fees should be firmly established and largely known in advance. Other costs such as taxes and inflation are less predictable but also chip away at assets. Fees are the component that can be influenced. It is for this reason that investors should keep a close eye on them and not be misled by terms such as 'total cost'.

At Scalable we have tried to keep things as simple as possible for our clients with our fixed fee of 0.75 percent. This includes management, custody, trading fees and operating costs. The ETFs we invest into average a fee of just 0.25 percent per year. So the total cost for our comprehensive service and the underlying investment driving your return is 1 percent. There are no initial charges, exit charges or performance fees.

1. Scalable Capital costs: 1% per annum (0.75% p.a. fixed fee + 0.25% p.a. on average ETF costs). Total Expense Ratio for a selection of major UK wealth managers: 1.85% p.a. (average charge paid to the wealth manager: 1.37% p.a., average fund charges of 0.48% – assuming a cost of actively managed funds invested into of 0.58% p.a. and an average cost of ETFs/ITs invested into of 0.39% p.a., with a 50:50 split between ETFs and managed funds). Source: Numis Securities pricing model Feb-2015, own calculation for averages.

Note: We re-calculate our average ETF fees on a regular basis to make sure they reflect current portfolio averages. The fees mentioned in this article were accurate at the publication date. To view our current fee structure please visit our fees page.

Image: Chris Lu/ Unsplash.com

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Simon Miller
UK CEO & UK CO-FOUNDER
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.