Part 1: What’s the Problem?
In theory, investing should be quite simple. On one side there are investors who need to put their money somewhere whilst they are not spending it and need to gain a return to avoid capital erosion from inflation or achieve higher growth rates to increase their wealth and lifestyle. On the other side there are companies, or governments, who need money to grow or invest.
Unfortunately, between the two sides, there is a jungle; the investment industry. This not only makes things more complicated than they really need to be, an industry needs to create and sell products to make profits. Often huge profits.
These profits have often been hidden in complicated investments or in mountains of paperwork that nobody (with a life) reads. The regulator is trying to make charges more transparent, but this just results in even more paperwork, which even less people read.
Charges are deducted from the product and therefore the pain of the fees is often cushioned, but if those fees had to be paid by the investor writing a cheque, they’d soon sit up and take notice!
But what effect do these ‘hidden’ fees have on the investment returns?
(Bear with me on this, it’s worth it!)
There are often three layers of charges in an investment, the product charge, the annual management charge and the advisers ongoing annual charge. These are usually paid from the investment after the initial advice charge. We’ll compare the most common annual adviser charge of 1% pa with 0.5% and compare a passive portfolio of funds with an average managed fund charge.
The initial advice charge is usually a percentage charge of the amount invested (in a survey, based on data provided by New Model Adviser, approximately 75% of advisers make such charges, the most common being 3%). We’ll compare this fee with a fee based upon an hourly rate.
For our example, we will assume ‘traditional charges’ of 3% initial and 1% adviser charge each year, with a time costed initial fee (much fairer) assuming an hourly rate of £195, with the work taking 6 hours and an ongoing adviser charge (to cover risk management, monitoring and reviewing) of 0.5%, which we’ll refer to as ‘professional fees’.
For a mid-risk portfolio, we will assume an average annual growth rate of 6% (and ignore the product sellers who will have us believe we can get much higher returns), but then take off all charges.
Prepare to wince…
Effective Growth Rates: After the Deductions
Traditional Charges Professional Fees
Average Annual Growth Rate % 6 6
Product charge % 0.38 0.38
Annual management charge 0.78 0.3
Adviser charge 1.0 0.5
Total deductions 2.16 1.18
Effective growth rate 3.84 4.82
Maturity Values: The Destruction from Compound Interest
(A financial calculator is invaluable for these calculations!)
Managed Fund Portfolio Passive Portfolio
Initial investment £100,000 £100,000
Term of investment (N) 20 years 20 years
Investment after charges (PMT) £97,000 £98,830
Maturity value (FV) £206,093 £253,379
Interest (1/yr) 3.84 4.82
Gain (less the initial £100,000) £106,093 £153,379
So, returning to the original question; Is The Investment Industry A Wealth Creator Or Wealth Drainer?
Look at the growth you didn’t get because of higher charges! Potentially a wealth drainer, I think…
Unfortunately, it gets worse! In my next blog, we’ll look at the effects of inflation and ask if the investment industry is using this as a smoke screen.
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