Making all your own investment decisions can be daunting, but our explanation of the costs involved, and a step-by-step guide on how to put all your investments in one place, can put you on the right track.
The cost of the investments you use can make a huge difference to the performance of your portfolio – up to tens of thousands of pounds over the long-term – so it is essential that you understand the charges for each product.
Actively managed funds
Actively-managed funds are run by a fund manager who picks stocks and tries to outperform an index or benchmark. An annual management fee is paid, with some funds applying a performance fee if the manager outperforms above a certain level. Some initial fees can also apply. Many funds express their annual costs as a total expense ratio (TER), which includes management fees as well as some other charges.
Open-ended funds
An open-ended fund, also called a unit trust, is made up of units that can be created by the fund manager when investors want to buy, and cancelled, or redeemed, when investors want to sell.
Pros: Open-ended funds offer a straightforward way of gaining access to a particular market or sector with an experienced fund manager who will try to outperform the benchmark. They tend to be viewed as more suitable for less experienced investors.
Cons: If you invest in an open-ended fund directly or through commission-based financial advisers, you can be hit with an initial charge of 5 per cent. There are ways around this – if you buy through a fund platform or through a self- invested personal pension, the initial charge is likely to be much lower or waived. However, TERs on open-ended funds still tend to be above 1.5 per cent.
Closed-ended funds
A closed-ended fund is a company that is listed on a stock exchange, also called an investment trust or investment company. The structure is therefore very different from an open-ended fund, but the two sorts of funds often invest in similar ways, buying and selling shares in other companies.
Pros: An alarming number of financial advisers describe closed-ended funds as “too complex” for retail investors, but this is likely to be code for the fact that closed-ended funds do not pay commission in the form of an initial charge.
Closed-ended funds usually have lower overall charges than open-ended funds. TERs are normally less than 1.5 per cent and, at larger and older closed-ended funds, they are less than 1 per cent.
Closed-ended fund managers argue they are better placed than open-ended managers if there is a market sell-off.
An open-ended fund manager may have to sell stocks to meet requests from investors to encash their shares, while a closed-ended manager never has to “panic sell” in this way.
Cons: Shares in a closed-ended company can trade at a discount to the underlying value of the company’s assets, known as the net asset value. This can be frustrating for existing investors. However, discounts can also be seen as a benefit for new investors.
While closed-ended funds generally have lower TERs than open-ended funds, this is not always the case. Specialist funds including funds of hedge funds tend to have larger TERs.
Passively-managed funds
Passively-managed funds aim to replicate the performance of an index or benchmark and do not have an active fund manager in charge of stock selection. So fees are nearly always lower for a passively-managed fund.
Advocates of passive funds would argue that many actively-managed fund managers fail to outperform their benchmarks while taking a large fee.
Tracker funds
Tracker funds deliver returns in line with a stock market index. They are structured as open-ended funds but have lower charges than actively-managed versions. They aim to match the returns of an index, either by replicating every stock in the index or by choosing certain stocks that are likely to closely match the returns of the index, known as the “sampling” approach.
Pros: Tracker funds are cheaper than most actively- managed funds, with annual charges of between 0.15 to 1 per cent. They often have no initial charge. There are also no dealing charges.
Cons: Don’t assume that a tracker fund will replicate the index exactly. Some manage to underperform it while still charging relatively high fees, so look at the performance record.
Being forced to track an index can also result in sector bias if the index is not well diversified – the FTSE 100, for example, has a strong bias towards financials and commodities.
Exchange traded funds
ETFs aim to track an index, sector or asset class. They work in much the same way as index tracker funds except that they are listed on a stock exchange and can be bought and sold at any time through a broker.
Pros: Like closed-ended companies, ETFs are shares that can be bought and sold at any time, offering liquidity. They also offer diversification if they are tracking an index. ETFs are exempt from 0.5 per cent stamp duty when they are traded, unlike other shares – including those of closed-ended companies. Investors buying ETFs only pay their stockbroker’s commission to buy in, and TERs are usually between 0.15-0.5 per cent.
Cons: ETFs can have tracking errors – deviating from the performance of the index they track – and these will differ according to different ETF providers.
It may make more sense to buy an ETF in a larger, more efficient market – such as the US – where an active fund manager is less likely to outperform the index. But in markets where stock-picking and local knowledge has more value – for example, in certain Asian markets – an ETF may not offer such good value.
