David Prosser compares fees between open-ended funds and investment companies and the recent fee cuts in the closed-ended space.
It is so easy to overlook the impact of fees on investment returns. On a term sheet, the fact that one fund charges a handful of basis points more than another looks neither here nor there today – yet over time, even the smallest variation can make a huge difference. On a £100,000 fund earning an average return of 6% year, a 0.1 percentage point reduction in the annual fee will save the investor more than £8,000 over 25 years.
This is why the price competition between investment companies and open-ended funds matters so much. It used to be the case that the former were almost always cheaper than the latter, which had to bear the cost of paying sales commissions to financial advisers. Then, eight years ago, such commissions were banned, enabling many open-ended funds to reduce their charges and to compete more aggressively with their investment company counterparts.
Now, however, the status quo is being restored. Data published last year by the stockbroker AJ Bell found that the average investment company levied an annual fee of 0.91%, compared to 0.97% amongst comparable open-ended funds. The AIC’s latest data suggest 0.82% is more like the average investment company charge if you weight by market capitalisation.
Over the last couple of years, we’ve seen a steady flow of investment companies reducing their charges. As Money Observer magazine reports this week, 18 funds cut their fees in the first half of this year alone.
It’s not just that headline charges are coming down across the sector; many funds are also changing the way they levy fees. Some of the industry’s biggest investment companies have introduced tiered charges, with smaller percentage fees levied on assets under management above certain thresholds. Scottish Mortgage, for example, charges 0.3% a year on the first £4bn of assets under management, but only 0.25% thereafter.
This is intrinsically fair. Many of the costs that collective investment funds incur are subject to economies of scale. Large funds that charge a single fee are effectively earning higher profit margins than their smaller counterparts – why should investors not enjoy some of the benefits of scale?
By and large, however, tiered fees are the preserve of the investment companies sector. While there are some very large open-ended funds that now enjoy huge economies of scale, it is unusual to see them pass on any savings in this way.
Why should that be? Well, one of the interesting things about the charges debate is how it cuts to the chase of the fundamental difference between investment companies and open-ended funds.
An investment company is a company in its own right, with an independent board that has a fiduciary duty to serve the interests of shareholders. That means it is bound to negotiate the best possible deal with any third-party that supplies services to the company – including the investment manager. By contrast, an open-ended fund is a product created by its manager; as with any product, the provider seeks to maximise profit by charging as high a price as it thinks the market will accept.
In other words, in a well-governed investment company, investors should have someone on their side, fighting to secure them a better deal. In an open-ended fund, such allies don’t exist.
Charges aren’t the be-all and end-all, of course. But they are a known quantity today, unlike future investment performance. It makes sense for the starting position of any adviser or investor choosing a fund to be that the cheaper deal is the better one.