How to keep investment charges to a minimum

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When looking at potential investments it can be very tempting to base your decision on past performance figures alone, but while these should be taken into consideration, it is extremely dangerous to overlook another vital component: charges.

Fees vary enormously and can have a dramatic impact on your profit. After all, there's little point in buying a fund that delivers a bumper double-digit return if you end up paying most of it back in charges, says Jason Witcombe, spokesperson for Evolve Financial Planning.

"If one fund charges 0.5% a year and another charges 1.5%, the more expensive fund will have to produce an extra 1% just to keep pace," he explains. "That's a big ask in the current environment and most of the higher-cost funds won't be able to achieve this."

These differences might not sound much but the impact can be vast when measured over time, due to what is known as the cumulative 'drag' effect. For example, an £11,280 fund investment - the current annual limit for ISAs, growing by 7% each year - will reach £22,190 after 10 years before costs are added into the equation. However, annual charges of 1.65% would reduce this to £19,000, whereas fees of 2.5% would shrink it to £17,520, according to data from Lipper. Meanwhile, some low-cost index-tracking funds have annual charges of 0.3%, which would reduce the same investment over 10 years to a healthier £21,575.

The problem with fees and charges is that they aren't particularly transparent.

What charges apply and how much they are going to set you back can vary enormously and the whole process isn't always clear, according to Geoff Penrice, an independent financial adviser with Honister Partners. "There is the annual management charge (AMC) and then other costs, which, when added to the AMC, will be expressed as the total expense ratio (TER)," he says. "However, this isn't the full picture as there will be dealing charges on top of the TER."

By far and large it seems the industry likes to keep it this way - after all, the confusion helps to boost its pockets. Don't let this trick you.

Opt for passive funds

The good news is there are plenty of ways to reduce your expenses, in terms of the products available and how you go about buying and selling them. The most obvious way to reduce your costs is by opting for passive rather than active funds. These products are often referred to as trackers because they attempt to replicate an index, such as the FTSE 100, rather than beat it. As you are not paying a fund manager to make decisions, the annual costs will be lower at around 0.5%, rather than 1.5%.

Opting for a passive strategy doesn't automatically mean you will miss out on performance. Given that so many active managers underperform, it could be a wise move, says Penrice. It all comes down to individual funds. "It's unfair to assume lower-charging funds will outperform more expensive funds because a well run higher-charging fund may give much better returns than a poorly run cheaper fund," he says. "In fact, with strong-performing funds, the level of charges becomes relatively unimportant."

It's impossible to say whether active or passive strategies are better, points out Justin Modray, founder of website Candid Money. "Hedging your bets by combining both in your overall portfolio makes sense."

You may also want to consider exchange traded funds (ETFs), which have grown in popularity over the past decade. These provide access to a wide range of different investments, including exposure to various countries and asset classes, at relatively low cost.

Their passive approach makes them similar to tracker funds but the difference is that they are traded on an exchange similar to a share. This gives investors relatively straightforward access to a wide variety of investments on a real-time basis. Although ETF transactions are subject to the same fees as share transactions, they generally have lower management fees. They can also be traded at any time, offering investors much greater control in terms of timing.

Look at investment trusts

It is also worth looking at investment trusts, suggests Andy Merricks, head of investments at Skerritt Consultants. "Some unit trusts have a mirror investment trust, which will almost always be cheaper," he says. Investment trusts are quoted companies in which you buy shares, the price of which will be determined by supply and demand rather than the value of the underlying assets, meaning their value can fluctuate more than unit trusts, although fees are usually lower.

Trusts can also retain up to 15% of the income they receive each year and put it into their reserves. This process, known as 'smoothing', helps them pay dividends in more difficult years and is worth bearing in mind.

There are also other ways to cut costs. Using a fund supermarket could be a good idea. This enables you to hold your funds on a single trading platform, which can make it far easier and cheaper to keep track of your investments, says Patrick Connolly, spokesperson for AWD Chase de Vere. "They allow investors to select from a wide range of funds, and you may get a cheaper deal when investing through one."

Finally, don't forget to shield as much money as possible away from the taxman - the first port of call should be utilising the tax-efficient qualities of your annual ISA allowance.

Low-cost recommendations

Investment trust: Edinburgh Investment Trust (EDIN)

Fund manager: Neil Woodford

Dennis Hall, financial planner for Yellowtail Financial Planning, says: "I like this trust as it has a good manager at the helm who is prepared to take a position and hold it."

ETF: iShares FTSE Gilts (IGLS)

UK 0-5 years ETF

Jason Witcombe, spokesperson for Evolve Financial Planning, says: "This is worth a look. It is physically backed and has an annual total expense ratio of 0.2%. It is also short-dated so shouldn't be as volatile as longer-dated bond funds."

Tracker: HSBC FTSE 100 Index

Patrick Connolly, spokesperson for AWD Chase de Vere, says: "It is notoriously difficult for active fund managers investing in large-cap UK shares to outperform the index. This tracker fund gives exposure to FTSE 100 companies with an annual charge of just 0.25%."

Tracker: L&G Global Emerging Markets Index

Andy Gadd, spokesperson for Lighthouse Group, says: "For those prepared to take a higher risk over a longer time, economic growth in emerging markets is still strong. The objective of this fund is to provide growth by tracking the FTSE All-Share World Emerging Index."