The Cost of Investing - Are 'Hidden' Charges Eating Your Returns?

Author: Ray Prince
We live in interesting times.The investment bank Lehman Brothers has filed for bankruptcy protection, Merrill Lynch is being taken over by Bank of America and it's predicted thousands of bank employees will be picking up their P45s by the end of the month. If you have money invested in ISAs and personal pensions these may be worrying times. It's likely that you'll have a reasonable percentage invested in the UK, US and major economies' stockmarkets.With the major indeces, such as the FTSE in the UK, falling, you may be wondering if you should be taking any action.Should you leave the funds as they are?Should you 'switch' funds to reduce risk?And are the funds you are invested in actually performing when compared to funds of a similar nature?One key aspect to investing is understanding the impact that investment costs have on your overall returns.As you'll know, when you earn interest on your money in the bank, the return is 'net'. That is, there are no hidden charges that you need to be wary of. If the bank offers you 5% pa gross, you know you'll earn 4% after tax, or 3% if you're a 40% taxpayer.The situation is not as clear when you invest in a mutual fund.Let's look at equity ISAs (investing in Unit Trusts/OEICs) as an example.The costs you need to consider are:- Initial charge when you invest the money (could be up to 6%) - Annual Management Charge, typically 1.5% pa- Total Expense Ratio (TER), includes other costs including trustee fees, custodian charges, auditors, legal costs, printing and marketing, this typically adds 0.1 - 1.6% pa- Fund Trading Costs, incurred when the fund manager buys and sells shares within the fund, can add 1 - 3% paThe reality is that many investors are totally unaware that all these costs exist. Most will have heard of the first two as these are included in most fund marketing literature, but the last two remain a mystery to many.The good news is that the fund managers are now required to disclose information on all these costs, which means you can now discover how much you are paying and what you are paying for.Some investors believe that the TER includes all costs on their investment, but they are mistaken. The trading costs can, in some cases, double the ongoing costs to your investment.When times are good and markets are rising, meaning the value of your investment is increasing, it's all too easy to overlook how much you are paying in charges. After all, you're making 'free' money so does it really matter how much they are making from you?An easy trap to fall in to.Now that times are not too 'hot' it could be the right time to question how much you are paying your fund manager. Whilst it's prudent to take the long term view when investing, this should not just be an emphasis on performance.Reducing costs really does matter and could make a big difference to what your investment is worth in the future.You may be thinking that relatively small percentages will not make much of a difference, however compounded over time you could be incurring some considerable cost.As an example, let's look at a £100,000 investment over a period of 20 years growing at 7% pa. This would be worth £386,968 without deducting any annual costs.If we add in a TER cost of 1% pa the return would reduce to £320,713. If we increase the TER to 3% pa the return is further reduced to £219,112.I'm sure you'll agree that this is a massive difference!The Financial Tips Bottom LineAt a time when we are facing a period of slower economic growth and lower returns, investment costs and charges should stand out like a sore thumb to the savvy investor. These costs do exist and may well apply to your investment funds today. Maybe it's time you found out the truth?ACTION POINTIf you don't want to go through this research yourself, or simply don't have the time, then approach your Financial Adviser/IFA/Financial Planner (if you use one) and ask them to collate the information for you. Check what their charges will be for this exercise.Once you have all the data, seriously consider what alternative investment options you have such as passive and index funds. In fact, the reality may be that you do not need to take any risk with your capital to reach your financial planning goals so it may be better for you to hold the money in cash.
Ray Prince is an Independent Financial Planner with Rutherford Wilkinson plc, and helps UK Resident Doctors and Dentists get the best deals on mortgages, protection and investments, as well as helping them achieve their financial objectives. Click here for Financial Advice for UK Doctors and Dentists and to get your free retirement guide, How To Avoid The 7 Most Common Retirement Planning Mistakes. Rutherford Wilkinson plc is authorised and regulated by the Financial Services Authority.