How to keep costs down when investing

Whether you are putting money away for retirement – in a workplace pension or a Self-Invested Personal Pension (SIPP) - or investing for a specific goal in a stocks and shares ISA, fund charges matter because they can make a massive difference to your returns.

The good news is that charges are something investors can control. interactive investor has a fixed fee charging structure which means our costs do not increase as your investments grow in value. In contrast, other providers charge percentage fees which increase with your investments. Funds and investment trusts also levy a percentage fee, meaning they increase over time as your investments (hopefully) grow.

Active funds versus passive funds 

The trouble with active funds is that outperformance cannot be guaranteed in advance; investors are buying in the hope that the fund manager will deliver value by outperforming a comparable index. 

However, the possibility that they might provide a better return than the market is the key attraction of actively managed funds.  

If the fund manager makes good choices, performance can be great. But, if the manager is wrong, investors may have been better off buying the market through a passive fund, which has cheaper fees.
One of the core arguments for owning passive funds is that most fund managers cannot consistently identify the shares that are going to do well. 

As well as not outperforming the market, another downside with passive funds is that they do not protect capital in a market downturn – they will fall in line with the market. 

Active funds can take measures to protect capital when markets fall, such as moving into cash, or buying more defensive shares.

A simple way to understand the difference between active and passive is to think of active managers as trying to uncover needles (good shares) in a haystack (the market). Passive funds, meanwhile, buy the whole haystack, knowing that the needles are in there somewhere.

Mix and match passive and active funds to keep a lid on costs 

The core and satellite strategy can help investors keep costs down when investing. The core holdings are the heart of the portfolio, accounting for around 70%. They should be a small collection of solid investments that will not give you sleepless nights. Every investor will have different requirements but, in general, core holdings will have certain characteristics: be something you can buy and forget about, be less volatile, be low-cost and be diversified.

You might consider multi-asset passive funds such as the Vanguard LifeStrategy fund range, Three of the funds are members of interactive investor’s Super 60 list: 20% Equity, 60% Equity, and 80% Equity, which cost 0.22% a year. Passive funds that track well-known stock market indices – such as the MSCI World, S&P 500 and FTSE All Share – are also popular core holdings.

The satellite part of the portfolio - around 30% in this example - is where you have exposure to investments that are slightly riskier, but which have the potential to generate larger profits for investors. This is where you may consider paying a higher fee for active funds for potentially higher returns. Among others, you could consider adventurous funds that invest in smaller companies, Asia Pacific, and emerging markets. 

Other fund charges 

The reality is that fund fees are higher than the figures stated by fund providers, as some costs are not included in the ongoing charges figure, or OCF. The main one is trading costs, which are incurred when the fund manager buys or sells shares.

For those that levy them, there are also performance fees. There’s been plenty of debate over the years about whether such performance fees are a force for good or evil. On the one hand, an argument can be made that the yearly fee should be sufficient incentive for a fund manager to beat the stock market.

Conversely, supporters of performance fees point out that they  help align the fund manager and investors’ interests by rewarding superior performance.