How to prevent investment fees from eroding long-term returns

In a low interest rate environment, the power of compounding can make fee leakage a sizeable drain on your wealth

IN A LOW growth environment, high fees equate to long-term wealth destruction. In the year to date, most asset classes have struggled to post positive returns, UK inflation (on the consumer price index) is at 1.6 per cent, and interest rates remain at record lows.

In this context, the impact of fee leakage on your long-term investment returns is significant and, in some instances, also hidden. The Financial Conduct Authority (FCA) estimates that the total expense ratio (TER) incurred by investors is around 3 per cent per year. This means that your investments, taking into account inflation, need to make at least 4.6 per cent annually before your wealth starts growing. And this excludes the impact of tax.

You can, however, be clear on what you are paying if you ask the right questions of those who help to manage your money. There are a number of different fees that can be charged to clients, so investors should check and understand whether all costs are appropriate. Here are some of the most important:

This is the most common fee charged by banks and investment managers, and is levied in return for making discretionary investment decisions.

What you need to ask: What does my management fee charge include? Does the fee also include administrative charges?

Every time a trade is completed in your account, it costs you. Charges vary from 0.05 per cent to 0.5 per cent – this will usually be on top of the bid-ask spread and will depend on the size of an account, the frequency of trading and the underlying security.

What you need to ask: Does the investment manager add any additional commission onto any trade in any client account, or receive any retrocessions?

This is a separate fee which includes safe custody of the assets, reporting, statements, tax reporting, transfers and any other non-investment activity that takes place on the account.

What you need to ask: What is the charge? What is included within the custody and administrative fee?

Fees on these products are not always transparent, and typically consist of a 2 to 3 per cent upfront fee, with an annual management fee of around 1 per cent. A structured product, however, can often be replicated directly by purchasing the underlying constituents, rather than buying the branded product. If you are unable to get a clear answer to the below questions, you should choose a different, more transparent investment manager.

What you need to ask: What is the bank’s underlying fee? What is the set-up cost? If I try to sell the product half way through its life, are there penalties?

These are retail investor-related – professional investors typically do not pay front-loaded fees. They can be anything from 0.5 to 5 per cent of the initial investment, and in certain situations and jurisdictions can be rebated back to the manager who made the investment (known as retrocessions).

What you need to ask: Will my account be invested into funds that incur front-loaded fees? Are there any additional administrative fees or performance fees? Will any retrocessions received be rebated back to my account? Are there any penalties if I redeem from a fund?

While these were once very common in the finance industry, they are still prevalent today and you need to watch out for them. Essentially, an investment manager can invest a portion of its client’s account into a fund. The fund charges the client a 1.5 per cent management fee per annum, and in certain situations and jurisdictions a proportion of this charge could be rebated back to the investment manager. Retrocessions can occur from any transaction – as well as from investments into hedge funds, mutual funds and structured products. Some managers have used these fees to increase the revenue they generate from a client’s account over and above the management fee, though the Retail Directive in the UK has now limited this.

Questions to ask: When applicable, do you receive any retrocessions or rebates? Are these disclosed to the client and/or rebated back to the client’s account?

The quest for higher gains when interest rates are at historic lows can be expensive, and can lead to lower returns in the long term. More importantly, because of the power of compounding, additional costs or fee leakage over the long term can lead to wealth destruction. Clients need full transparency on the hidden fees and charges associated with investment management services and financial products. The FCA is working to increase clarity on fees and charges, but unfortunately its impact on banks (which are not yet providing the level of transparency needed) remains marginal.

Yogi Dewan is chief executive at Hassium Asset Management.