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.
With actively managed funds - those run by professional investors - there are no guarantees the chosen investments will add value by outperforming the wider stock market, for example a UK fund beating the FTSE 100 or FTSE All Share index. Such funds typically have a yearly fee of 0.75% to 1%.
Passive funds, which come in two forms - index funds and exchange-traded funds (ETFs) - aim to replicate the performance of an entire index. Some of these strategies cost less than 0.1%, but typically charge less than 0.25%.
Given there’s a fee, the passive fund will, in the majority of cases, underperform the stock market, but only very slightly. There is the occasional quirk when a passive fund outperforms – as some partially rather than fully replicate a stock market.
That gap doesn’t seem much - 0.5% if we compare the top end of the price range for passive funds of 0.25% versus the low-cost end for active funds of 0.75%. However, the difference eats into your returns more than you think if the active fund fails to outperform the market and by extension an index fund or ETF.
For example, £50,000 invested over 25 years and growing at 5% a year would be worth almost £18,000 more with an annual fee of 0.25% rather than 0.75%.
Based on the same 5% return over 25 years, a passive fund with a fee of 0.1% with the same returns as an active fund charging 1%, would leave investors over £32,000 better off.
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.
Learn more about investing
Learn how to make the most out of your investments with our useful guides.