What is an Investing Fee?
Investing fees represent the cost of investing and can occur across the whole process. They can take the form of broker fees, ongoing management charges, performance-related fees, or various other. Typically, investors focus on the product’s ability to produce attractive excess or risk-adjusted returns, but nevertheless, making a proper assessment of the costs and charges associated with an investment is essential. For example, an active mutual fund that produces a small above-benchmark return, but charges its investors high management fees, usually turns up to be less attractive than a passive fund, which tracks the index closely but offers more competitive ongoing charges. Therefore, the process of optimizing fees tends to enhance returns over the long term.
Key Learning Points
- Investing fees are the costs that investors face through the process of investing in a financial product or security. They can be related to broker, advisory, trading activities, or to the product itself.
- Collective investments are typically the preferred choice for retail and some institutional investors. They include mutual funds, exchange-traded funds, investment trusts, hedge funds, pension funds, and others.
- They apply various fees and charges to their products, the most popular (and arguably important) of which is the ongoing charge figure (OCF) or sometimes quoted as a management fee.
- Other types include a success fee, also known as performance fees, or charges related to the entry or exit of an investment. The latter two are almost non-existent (at least from a retail perspective), but however investors should still pay attention as historically they have been around 5% of the initial or end amount respectively.
What is the Ongoing Charge Figure (OCF)?
The OCF, which was previously known as the Total Expense Ratio (TER), is a standardized calculation used by fund groups to give an indication of the total cost that investors would pay should they buy their product. This number includes all costs associated with the investment such as professional investment management costs (i.e. the salaries of the portfolio manager and investment staff), marketing, administrative costs for running the fund, depository, custodian, audit, and various other costs. The figure is always given at the product’s official documents such as the prospectus, key investor information document, or factsheet, and is shown as a percentage of the money invested over one year. Put simply, this is how much investors would need to sacrifice per year for someone to run their money.
For example, if an active mutual fund has an OCF of 1%, an investor with $10,000 will need to pay $100 (10,000×0.01) in fees per year. This will cover all trading activity costs that occurred within the portfolio over the period (i.e. the portfolio manager’s purchases and sales).
Typically, fund managers give different OCFs for different share classes of the product. For example, institutional share classes tend to charge lower fees than retail ones even though the strategy is the same.
What is a Typical Investment Fee?
To give an indication if a fee is low or high, we need to first explore what is the structure of the product in question. To begin with, actively managed funds typically charge higher fees due to the higher costs they run to manage the fund. This is mostly incurred by the involvement of the human element within the decision-making process. Breaking this further down, active funds that invest in a more efficient area of the market, for example, large-cap US equities, are expected to charge lower fees compared to their peer which seeks to exploit rather inefficient segments such as smaller companies or emerging markets.
Example:
| Active Fund Name | OCF |
| T. Rowe Price US Large-Cap Growth Equity | 0.57% |
| BlackRock Emerging Markets Fund | 1.72% |
On the other hand, passive funds are known for their cost efficiency and in most cases charge just a fraction of what active managers do. They aim to replicate the performance of a benchmark index by using an algorithm and therefore limit human involvement. Similarly to their active peers, passive funds usually charge lower fees for popular market areas and higher ones for more niche products.
Example:
| Passive Fund Name | OCF |
| Vanguard S&P 500 | 0.07% |
| iShares MSCI Emerging Markets | 0.68% |
What is a 2 and 20 Fee Structure?
This type of structure is famous for hedge funds and consists of both management and performance fees. The ongoing management fee, which is charged as a percentage of the assets invested is 2% per annum. On top of that, the manager also charges 20% of the profits realized over a pre-specified threshold. Should that target is not achieved, the performance fee is not applied.
For example, a hedge fund manager has the mandate to outperform the MSCI Global Index by 5% (threshold) per year. If the fund delivers 11% excess return in one year, which is 6% on top of the threshold, the manager will retain 20% on those 6% excess returns. However, if the fund still delivers alpha, but let’s say 4% above the benchmark, the manager will not charge any performance fee. Overall, this model aims to align the interest of the underlying investors and that of the hedge fund.
Most hedge funds also include a high watermark clause, which only allows the manager to charge performance fees on the newly generated profits. Should the strategy make a loss, it must recover the losses before charging any performance fees.
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Conclusion
Investment fees really matter as investors will pay them regardless of performance generated through the period. Ultimately, investors should seek to find the right balance and get the best value for money rather than focusing on lower costs only. Over the long term, higher charges will certainly erode the real return of an investment, but nevertheless, some investors are happy to pay them as long as the fund can generate competitive returns. Usually, investment fees are paid as a deduction that is reflected in the daily fund price, so investors do not need to worry about making additional payments. However, when it comes to taxation, depending on the jurisdiction, investors are liable to pay income and capital gains tax.
