Private investors will pay lower annual charges for retail investment funds in future, according to industry forecasts. But, in the years ahead, they will need to take account of new performance fees, analysts warn.

Annual management charges for “passive” index tracker funds are already falling, as competition between providers of exchange traded funds (ETFs) and conventional open-ended investment companies (Oeics) intensifies.

In June, Vanguard, the pioneer of low-cost fund management in the US, sparked a mini price war in the UK war by launching a FTSE All-Share Index tracker Oeic charging 0.15 per cent a year. Although available only through fee-based independent financial advisers (IFAs), or to direct clients investing £100,000 or more, its launch was followed by price cutting from other institutions.

A month later, HSBC announced that the total expense ratio (TER) – a measure of the annual management charge plus other operating costs – on its index-tracker funds would fall to 0.27 per cent from September. Then, in August, the bank listed its first European ETF on the London Stock Exchange, tracking the FTSE 100 index with a TER of 0.35 per cent. This undercut existing FTSE 100 ETFs offered by iShares and UBS, which have annual management charges of 0.4 per cent and 0.5 per cent respectively. Only Lyxor and Db-x trackers offer cheaper UK trackers, both with a TER of 0.3 per cent.

Active fund managers, who aim – but frequently fail – to outperform stock market indices, may soon be forced to respond. Sheridan Admans, investment adviser at The Share Centre, the broker, says: “There is going to be pressure from ETFs – we’ll see more of that. The ETF market in the UK is still in its infancy.”

Lipper FMI, the fund data provider, reached a similar conclusion in its “Review of UK Fund Fees” earlier this year. According to Ed Moisson, head of consulting: “The increased appetite for lower cost ETFs in Europe does not yet represent a wider shift among retail investors towards greater cost sensitivity. But there are reasons why such a shift may yet occur.”

He points out that one of the main components of actively-managed funds’ higher TERs is the “trail” commission paid to the IFAs who sell them – typically 0.5 per cent a year. Now that the Financial Services Authority (FSA) has announced a ban on commission from the end of 2012, in favour of fees for advice, investors should see the annual deductions from their investments reduced. “Such a development would clearly open up the possibility for more retail investors to be paying lower fund charges,” Moisson concludes.

However, while lower charges should benefit both fund managers and investors in the long term, such a shift may take longer than three years. “In this context, another fund worth looking at is Fidelity’s UK Index fund and the significant cutting of its TER in September 2005, from 0.7 per cent to less than 0.3 per cent,” says Moisson. “This has not resulted in an earthquake in the industry that some predicted.”

IFAs also believe that a sudden emphasis on lower charges is unlikely – and, for some funds, inappropriate. “It would be a nice thought, but don’t see it happening overnight,” says Hugo Shaw, investment manager at Bestinvest. “A client mentioned the Vanguard tracker fund as something she should move her portfolio into – the person who had promoted it to her had promoted it solely on basis of cost. But what about strategic bond funds? What sort of benchmark do you pick for that?”

Many fund managers argue that investment performance against a stated benchmark will be the only fair way to assess charges in the future. Last month, three quarters of the 62 fund management companies polled by investment group Skandia said they expected annual percentage charges for actively-managed funds to be lowered, while two thirds expected the use of performance-related fees to increase. These fees – of between 10 and 20 per cent of any return achieved above a benchmark measure – are the norm for hedge funds, and have already been introduced on absolute-return funds.

But some advisers fear they will become more widespread – being adopted by fixed-interest and property funds – and will be incurred on modest returns. As Mark Dampier, head of research at Hargreaves Lansdown, put it: “It’s just another way of upping costs . . . you have to be very careful about the benchmarks they use . . .  they can be quite unimpressive targets.”