Exposed: The "clean" fund share classes that cost you more

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Life was meant to become easier for fund investors after the ban on commission-driven financial advice was introduced at the beginning of this year following the implementation of the Retail Distribution Review (RDR).

In particular it was meant to make it easier for investors in open-ended funds to understand how they were being charged and for what.

In reality, investors are becoming increasingly confused, especially now that HM Revenue & Customs (HMRC) has announced it is to start taxing "rebates" of fund charges from 6 April. Investors will now have to consider not only what fund they want to invest in but which type of share class they should choose. Which type is best will depend on the investment manager, the route they choose to invest and on whether they are investing directly in a fund or through an ISA or a self-invested personal pension (SIPP).

In the past, annual management charges on actively-managed equity investment funds were typically 1.5%. If you bought funds through an adviser, this charge was split three ways. The investment management company kept 0.75% as its fee, the adviser who sold the fund was paid an annual "trail" commission of 0.5% and the platform(s) which facilitated the sale and administered the fund was paid 0.25%.

However, direct-to-consumer platforms including Hargreaves Lansdown, Bestinvest, Alliance Trust Savings and Interactive Investor are also eligible to retain the adviser's trail commission.

Many of these platforms rebate part of the typical 1.5% annual management charge to the investor, handing back all or part of the 0.5% commission that should have gone to the adviser. Interactive Investor goes one step further and also rebates part of the platform charge, bringing its rebates up to around 0.64% and the average net annual management charges on actively managed funds down below the 1% mark.

These are rebates which HMRC will now be taxing at the investor's marginal rate of income tax, unless the fund is held within an ISA or a SIPP. So a higher rate taxpayer could lose almost half of the value of the rebate in tax. This is despite the fact that, as Stuart Welch, chief executive at TD Direct Investing, has pointed out: "The reality is that trail commission rebates on funds are merely giving investors their own money back, in most cases."

As a consequence it is widely predicted that there will be a general move towards favouring the "clean" share classes, which exclude trail commission from their annual charges, which fund providers have introduced as a result of RDR.

These funds appear to have lower annual management charges. Instead of having a so-called "dirty" annual management charge of 1.5% the clean share class may have a charge of 0.75%. But not in all cases.

With some funds, the annual management charge is actually higher on the clean share class than the net charge an investor would currently pay after receiving a rebate on the dirty share class.

Indeed, clean share classes are frequently more expensive according to AdviserAsset, an organisation which has recently compared ongoing annual charges on clean and other share classes. In an open letter to the Financial Services Authority (FSA), AdviserAsset director Colin Turton pointed out: "Of the 1,317 clean share class funds analysed 66.4% could be obtained at a lower cost via another class of the same fund after the application of rebates. Only 21.6% of the sample could be obtained at a lower cost with the clean share class."

Some fund managers have also used the move to clean share classes to increase their effective annual management charge for some funds.

Aberdeen Asset Management (ADN) is one of the groups that has pitched the annual management charge on its clean share class at 1%, rather than 0.75%, on a number of its funds including Aberdeen Emerging Markets Bond, Aberdeen World Growth & Income and Aberdeen World Equity.

This means investors can get a better deal by buying the original "dirty" share classes in these funds through a platform such as Interactive Investor, where the net annual charges on these funds after rebates are 0.86%, 0.61%, 0.86% respectively.

Aberdeen spokesman James Thorneley explained the reason for its 1% charge on some funds. "We have done this to bring the charges on these funds into line with what we are charging for them in other parts of the world so there is consistency."

While many of Aberdeen's clean share class fees are lower than the old-style bundled share structure, Thorneley conceded that the management charge Aberdeen received from these shares was now effectively higher than from old-style shares.

JPMorgan Asset Management is another group where the clean share classes in many funds have a 1% annual management charge. However, Keith Evins, head of UK funds marketing at JPMorgan Asset Management, explained: "There is no commission built into these share classes but they do still contain platform fees. Rebates to platforms will continue until January next year so we have maintained the status quo, we are not making any more money with this share class."

He says that when the FSA publishes its platform rule paper in the next month or two, the situation will be clearer. This platform paper is expected to confirm that payments from product providers to platforms and cash rebates to customers will be banned.

Justin Modray, founder of comparefundplatforms.com, commented: "Platforms and discount brokers offering rebates won't want to lose customers, so will be under increased pressure to shift to the transparent 'clean' fund unit model, where cheaper fund versions without commission and platform fees built in are used and customers instead pay an explicit administration fee to the platform concerned.

"However, this could prove a big headache for larger platforms. For example Hargreaves Lansdown currently pockets a healthy margin by collecting average annual commission of 0.77% from fund managers before giving a modest rebate to customers. This commission, which Hargreaves Lansdown doesn't disclose for individual funds, is effectively an annual fee that most customers probably don't realise they're indirectly paying to Hargreaves Lansdown via fund charges. If Hargreaves tries to maintain this margin under a clean pricing system those customers could be in for a very rude awakening."

However, Colin Turton fears another issue may arise to complicate matters. He said: "The FSA assumes that there will be only one clean share class but I see a heightened risk of a move to multiple share classes with the largest platforms negotiating lower charges and this will raise barriers to re-registrations between platforms."

In the meantime, investors will have to consider which share class is the most cost effective for them. As rebates will not be taxable within ISAs and SIPPs, they will be best off buying old-style share classes and taking a rebate in most instances. For direct investment, however, clean share classes are likely to be the better option so that tax is not incurred.

There is still the possibility that the government may be persuaded to overturn HMRC's decision to tax rebates. Whatever the outcome, many investors are finding themselves worse off by opting for a clean fee share class than in an old-style share class with rebates. HMRC's decision adds a further layer of confusion for investors and is arguably a disincentive to invest, whether inside or outside an ISA or SIPP.