The higher charges imposed by actively-managed funds are encouraging more private investors to favour passive investing and switch into cheaper exchange traded funds (ETFs), advisers claim.

Assets held in ETFs hit a record $933.5bn at the close of the third quarter, up from the $789bn reported in the previous quarter, and a considerable increase on the $39.6bn reported in 1999, according to Barclays Global Investors.

The choice of ETFs on offer has also increased. More than 1,800 ETFs are listed on 40 exchanges and, this year, the number of ETFs registered in Europe outstripped the number in the US – 783 are listed in Europe compared with 721 across the Atlantic. Some $204bn is now held with ETF providers in Europe.

And while unit trusts and investment trusts still see much larger inflows, ETFs are cheaper. The average total expense ratio (TER) for equity ETFs in Europe is just 0.37 per cent. The TER for the average equity index tracking fund is 0.87 per cent while the average active equity fund has a TER of 1.75 per cent.

Whether fees and costs drag down funds’ performance is now a question triggering much debate among analysts.

Alan Miller, a fund manager who runs Spencer-Churchill Miller Private, argues that equity investors in the UK could be paying up to £5.8bn a year in hidden charges that are not included in a traditional fund’s TER.

Commissions for share dealing, taxes, marketmaking spreads, interest on borrowing and entry/exit commissions are some of the added expenses not factored into a fund’s TER, which only reflects a fund’s annual operating costs, says Miller.

By Miller’s calculations, the average cost of a typical UK All Companies unit trust is as much as 2.8 per cent even if an investor holds a fund for five years. If the turnover of holdings in the fund came close to 60 per cent, another 1 per cent per year would be added to costs. Miller argues that TERs should be scrapped and replaced by the Total Cost of Investment Ratio, which would calculate a wider range of costs.

“These hidden charges act as a significant drag on performance, particularly when overall returns are low,” he says. “It’s time for a new calculation to be adopted that includes actual management fees and all other charges impacting on investors’ total returns.”

However, the Investment Management Association (IMA), the industry trade group, last week published research to support the view that funds’ performances are not dragged down by “hidden” costs. Over 10 years, an investor with shares in a FTSE all-share tracker fund would have received 0.55 per cent a year below the return on the index, the IMA’s research showed. This compares with an average TER of 0.82 per cent for these funds.

“The IMA’s research explodes the myth that investors are subject to large hidden charges in their funds,” says Richard Saunders, IMA’s chief executive. “Investing isn’t cost-free, but examination of the facts shows that both active and passive fund managers have a good story to tell.”

But the IMA’s results drew criticism from fund managers who questioned the group’s methodology. “To suggest that dealing charges and other costs of investing do not drag down performance is frankly ludicrous,” says Jason Butler, an adviser with Bloomsbury, in response.

Fees and charges vary widely by fund categories. Annual management charges tend to be lowest for index trackers and highest for absolute-return funds (see graphs above). This is because absolute-return that take short positions tend to impose hedge fund-style performance fees.

Upfront costs should also be tracked. These tend to be as high as 4 to 5 per cent of the total value of the investment for unit trusts and open-ended investment companies, as well as absolute-return funds.

On top of an initial fee of 5 per cent, BlackRock’s UK Absolute Alpha fund charges an annual management charge of 1.5 per cent plus a 20 per cent quarterly performance fee if returns over a set period exceed three-month sterling-based Libor (the interbank lending rate), which this week hovered at less than 1 per cent.

Cazenove’s UK Absolute Target fund, managed by Tim Russell, also levies a 5 per cent initial charge, along with a 1.25 per cent yearly management fee and a 20 per cent fee if the fund’s net asset value (NAV) exceeds the highest NAV seen at the end of all previous quarters when shares are cashed in.

Portfolio turnover is another consideration – particularly for those investing in an actively-managed fund where trading is more frequent, as this could rack up extra dealing costs.

If an annual portfolio turnover level is 56.6 per cent, this suggests a usual stockholding period of just under two years while a level of 94 per cent indicates a holding period of 13 months or less, according to Lipper.

The turnover reported by absolute return funds – which take long and short positions – is even higher. The annual turnover rate of JPMorgan’s Cautious Total Return A fund is 222 per cent while Threadneedle’s Target Return fund’s level is 281 per cent.

The scrapping of the “trail” commissions now paid to financial advisers – typically 0.5 per cent a year – from the end of 2012 will reduce actively-managed funds’ higher TERs and reduce costs.

But investors are being encouraged to switch out of active funds – which often fail to outperform stock market indices – before the ban on commissions by the Financial Services Authority (FSA) is in place. Investing about £1.50 in an actively-managed unit trust obtains the market rate of return on £1, according to the FSA’s calculations.

But if an investor buys into an index tracker, the market rate of return on £1 requires an investment of £1.10-£1.25.

The surge in interest in ETFs, which have TERs of 0.2 per cent to 0.75 per cent, comes in response to higher fees and charges on actively-managed funds, according to advisers.

In the UK, ETFs offer an increasingly broad spread of exposure. One popular ETF, iShares FTSE UK Dividend Plus, tracks the performance of a basket of high-yielding shares. Others offer exposure to investments such as infrastructure, the water industry and private equity, as well as global stock markets and private equity companies.