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Industry guilty of hidden charges

When you go into the supermarket to buy food, you typically ask yourself two questions – how much does it cost and what is in it? Is the investment world any different? It shouldn&#39t be.

Unfortunately, the costs of running a fund are not as clear as you might expect and the fund you are buying may not be what you think it is either. Maybe all funds should carry a label detailing additives and preservatives, just like food.

What are the hidden costs in running an investment fund? There are three costs involved – the initial charge, sometimes referred to as the bid/offer spread, the annual management charge and the total expense ratio.

The annual management charge is simply the ongoing fee levied for running the fund. It covers the costs of the fund manager, the research and the admin system.

The total expense ratio includes the annual charge as well as:

Depository charges.

Custody charges.

Audit fees.

Registration fees.

FSA compliance fees.

On average, if an annual charge is 1 per cent, the TER will be 1.2 per cent – an extra 0.2 per cent. Sometimes, a fund group will bear the additional costs but this is very rare. So what is an extra 0.2 per cent charge among friends?

Well, in the new 1 per cent stakeholder environment, it is probably the difference between a fair or negligible amount of commission being paid out. Stakeholder providers have apparently taken account of the extra costs of total expense ratios in their multi-manager fund calculations. I will wait with interest to see if, in a year&#39s time, any of them have miscalculated and broken the 1 per cent ceiling.

What should you look out for? The total expense ratio should be reflected in any life company quotes – that is the rule – but does it happen? Why not ask your friendly life office regional consultant?

Also, be aware that most life insurance and fund group marketing departments only feel the need to quote annual charges in their marketing literature. It is up to the IFA to ask the difficult questions and get to the bottom of what the actual cost is, rather than having to explain to clients in a few years time why their payouts are not as good as expected.

If you cannot get the answers you are looking for, ask for a copy of the fund prospectus. By law, this includes all charges.

In most fund literature, you will see the bid/offer spread quoted as 5 per cent. However, 5 per cent is typically not the charge you will pay. The buying and selling charges fluctuate on a daily basis so, on average, another 0.2 to 0.3 per cent needs to be taken into account.

What is worrying about this is that many key features documents I have seen recently not only do not disclose potential spread charges but do not even mention them. Again, blame the marketing departments and ask your friendly consultants to explain what the spreads are.

Stakeholder has brought another interesting twist to the investment story. Most stakeholder plans are now offering institutional funds into the retail marketplace. Which is best – retail or institutional? This is an impossible question to answer unless you compare retail and institutional funds on a true like-for-like basis.

First, let us look at cost. Economies of scale mean you would naturally expect an institutional fund to be cheaper. The table on the opposite page shows a comparison of costs.

As you would expect, institutional funds are on average cheaper by almost half. However, how many institutional funds pay renewal commission of up to 0.5 per cent? Not many. So, if you strip out 0.5 per cent from the retail costs, the charges are now somewhat more comparable.

Another interesting point to note is that none of the average institutional total expense ratios would work in the new stakeholder environment. This leads me to believe that the institutional stakeholder funds will be nothing more than managed funds – it seems unlikely that sector-specific funds will be available.

How do you compare like for like from a performance point of view? This will be difficult as most stakeholder funds do not have any track record, so performance comparisons against retail funds will be difficult. It might be worth considering the following:

Only half the institutional funds in the market have a true investment mandate. The other half are run as pseudo-trackers which compare themselves against other funds in the market and rebalance each month to maintain an average asset allocation.

Funds with a mandate are still set up with very tight investment guidelines that allow the fund managers little freedom. Most mandates are set to beat a chosen index by 1 or 2 per cent, so are not suitable for true stockpicking fund managers.

Perhaps this is one of the reasons why so many institutional fund managers have jumped ship to start running the new flavour-of-the-month hedge funds.

Is the type of fund your client wants to invest in slightly out of the norm? A sector fund such as healthcare is unlikely to be available as an institutional fund as the costs of running the fund would not allow for this.

Find out who is running the institutional fund. Is it a named fund manager known in the industry or simply the new graduate cutting his teeth?

It looks like the investment market has just got a bit more complicated, thanks to the Government.

Make sure you know the true costs of buying a fund.

Do not think that stakeholder funds will look and act in the same way as retail funds.

Make sure that any life company quotes you are giving out truly reflect the fund costs.

If you buy an institutional fund through a stakeholder plan, ask how the fund has been run, what the past performance has been and what mandate the fund manager is working to.

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