New rules on investment-fund charges let you know what you're paying for

Investment-fund charges have always been complicated and controversial, but it is hoped the sweeping changes that have just come into force as part of a regulatory overhaul will help make the process more straightforward and cheaper.

As part of the long-awaited retail distribution review (RDR), financial advisers can no longer receive commission from fund-management groups for recommending their products.

This has heralded a major change to the way fees are levied on investments bought through advisers, and although it's still too early to say whether it will result in charges coming down, it should help make the entire process a lot more transparent.

What is the background to these changes?

The aim of the RDR is to raise standards across the industry, provide greater clarity for consumers, and tackle concerns that adviser remuneration could result in biased recommendations being made to investors.

In the words of the Financial Services Authority (FSA) it is all about "establishing a resilient, effective and attractive retail-investment market that consumers can have confidence in and trust at a time when they need more help and advice than ever with their retirement and investment planning".

What was the problem with fund charges?

Until now, fees associated with buying funds, such as the costs of advice, platform levies and the expenses incurred by the fund manager for running the portfolio, have been bundled together meaning it wasn't always clear how much each element cost.

Generally it is assumed that of the 1.5 per cent average an investor was charged, the manager would take 0.75 per cent, the adviser 0.5 per cent and the platform 0.25 per cent. However, this is by no means certain and has been behind calls for more transparency.

So how is RDR changing this perception?

These combined charges are now being unbundled to make the entire system simpler and easier to understand. Although it's likely to be a fairly long process before the new regime is working smoothly, the idea is that it will be seen as another step towards a more professional industry.

A number of fund-management groups are also in the process of launching so-called clean-share classes that don't include any commission. They just contain – on average – the 0.75 per cent fee for the fund itself, enabling the investor to negotiate with their advisers and platform providers.

The problem is there's no standard for these new classes yet, points out Justin Modray, founder of website Candid Money.

"Some clean-share classes still include fund-platform fees of around 0.25 per cent," he points out. "Investors need to check the annual charge of the fund being used and it should generally be at least 0.5 per cent a year cheaper than the traditional retail class."

Anybody can be eligible for the new share classes and it depends on with whom you invest, adds Patrick Connolly at AWD Chase de Vere.

"The clean-share classes might not work out any cheaper if you are still wanting to pay for advice and a platform, so speak to your adviser – if you have one – and ask them to help you get a breakdown of the costs involved," he says.

Will you definitely be affected?

This all depends on how you buy your funds. There are three main ways of purchasing them: via execution-only brokers; directly from the fund-management groups themselves; and through financial advisers.

Execution-only brokers

At the moment nothing has changed and the charges remain the same, says Mr Connolly, a certified financial planner at AWD Chase de Vere.

"They will involve an initial fee, which has traditionally covered marketing costs incurred by the investment house, as well as any commission, but these are usually discounted to close to zero," he explains.

Then there is the annual charge of, typically, 1.5 per cent.

"This is usually made up of 0.75 per cent to the investment company, 0.25 per cent for the platform, and 0.5 per cent for a financial adviser," he adds. "Even though they didn't give advice, they will generally still take the 0.5 per cent for their trouble."

Although execution-only businesses are still working on this basis today, the FSA is expected to eventually ban them from earning commission.

Directly from investment companies

The reality is most fund-management groups won't take business directly from private investors because of the administrative headaches involved and the fact they are not inclined to effectively compete against the distribution channel of financial advisers. For the few groups which do accept direct business, you typically won't get anything in the form of a discount.

Financial advisers

This is where the rules have changed. The adviser and platform fees are both being stripped out of investment-fund charges. If you buy a fund through an adviser, the fund itself in its pure sense will have no initial charge and will only have the investment-fund charge.

This is good news for investors, according to AWD Chase de Vere's Mr Connolly.

"If you buy through an adviser, you can see clearly how much is taken by the fund manager. You only pay for a platform if you use one, and you can negotiate with your adviser as to how much they take."

However, you need to keep your wits about you, warns Mr Modray,

"Financial advisers will charge fees and these might end up higher or lower than the equivalent commission, so it's important to check exactly how much you're paying overall."

Will this make charges cheaper?

It's hard to say at this stage.

If you pay initial adviser charges, this is how it would work out: If you invest £5,000 and, for example, you agree with your adviser that they will take an upfront fee of 2 per cent, it will be very clear that on day one your investment is worth £4,900 and the adviser has taken out £100.

If you pay annual adviser charges from the fund – at a fee of, say, 1 per cent – the charges you pay will be added to the 0.75 per cent investment-manager cost, giving a total annual charge of 1.75 per cent. If you are then using a platform charging 0.25 per cent each year your overall annual charge is 2 per cent and you can see clearly how much is going to each party.

Other charges may apply

Remember, if you choose a fund with a performance fee that rewards the manager for returns above a certain level – there aren't that many around but a number of the so-called absolute-return portfolios have them – then they will still apply whatever route you choose.

Consider other options before buying a fund that has the ability to levy a performance fee. At the very least know what this watermark is and whether it's too easily achievable. The last thing you want is to pay over the odds for a fund return that is no better than average.

How can you cut your costs?

You could avoid paying for an adviser, although you must bear in mind that if it all goes wrong you won't have anybody to blame but yourself, warns Geoff Penrice, a chartered financial planner with Astute Financial Management.

"In the past, many investors thought advice was free – which, of course, it has never been in reality," he says. "Although charges will now be more transparent, there is a risk that investors try and arrange their own investments without taking advice and that very often leads to bad choices."

If you're convinced you don't need advice then shop around as you can get a good deal from execution-only firms by seeing what's available and examining the various terms. Cavendish Online, Alliance Trust Savings and Interactive Investor are worth a look.

There is always the option of trying to negotiate lower charges with your adviser, although you're only likely to succeed with this if you have substantial sums to invest as they will be keener to retain your business.

Other ways to be more cost-effective: the first possibility is choosing to invest in comparatively cheaper, so-called passive-investment strategies rather than paying for the services of an active fund manager who could traditionally generate better returns through their experience in stock picking.

These tracker funds aim to replicate an index, such as the FTSE 100, rather than trying to beat it, with the main advantage being that this can be done at a much lower cost than an actively managed fund – around 0.3 per cent instead of 0.75 per cent plus any adviser fee.

It's also important to ensure your investments are tax efficient.

You should maximise the use of individual savings accounts which are shelters that enable your investments to grow free of both income and capital gains tax. You can currently invest up to £11,280 a year in this way.