How Much Does it Cost to Invest in Investment Trusts?
Investment trusts are a good investment vehicle for investors who require the diversification that a collective investment scheme provides. So, too, are unit trusts and open ended investment companies (OEICs), and this means that investors are often faced with a choice to make between the three schemes.
One advantage that investment trusts have over unit trusts and OEICs is that of cost: not only does it cost less to make an initial purchase, but the annual management charges suffered by an investment trust tend to be lower, too.
Structure and Law
An investment trust is run by an independent board of directors, and the remit of this body is to ensure that the company works for the best interest of its shareholders. It is therefore in the interests of the board to make certain that the costs of the company are held as low as possible.
On top of this there are some other expenses that investment trusts just don’t have. For example, an investment trust company is prohibited by law from advertising its funds whereas a unit trust can be advertised.
Being a closed end fund, an investment trust also doesn’t have the expense of cancelling and creating units as the need arises that unit trusts and OEICs incur.
The costs of buying investment trust shares
Investment trusts are publicly traded companies, with shares changing hands on the London Stock Exchange. When an investor buys or sells investment trust shares, he will do so through a broker. The broker will charge a commission for this service, though it is now commonplace to be charged a fixed fee (of around £8 to £10) particularly if dealing through an online broker. On top of this, when an investor buys shares there will also be a 0.5% stamp duty to pay.
Shares are bought at the offer (or ask) price as quoted on exchange, which will be a small amount above the price at which they could be sold if the trades were to happen simultaneously. The difference between the buying and selling prices is called the spread.
Unit trusts also trade with a spread, though they will be subject to an initial charge. This is either retained by the unit trust company, or passed over to the financial adviser who has recommended the investment. This initial charge is usually of the order of around 3%, but can be as high as 6%. OIECs are also subject to the levy of an initial fee, though trade on a single price structure, with no bid/ ask spread.
Annual Management Charge (AMC) and the Total Expense Ratio (TER)
Annual management charges are levied to pay for the cost of running and administering funds. There are a number of costs that are added together when calculating the AMC, and these typically add up to around 1.5%. However, this is not the only costs that are applicable to managed funds. There are also costs such as auditor, legal, and trustee fees to take into account.
When all these charges are added together, they produce the Total Expense Ratio (TER) which is considered to be the most accurate measurement of the ongoing cost of owning a fund.
According to research conducted by Lipper in 2010, the average TER for an investment trust was 1.2% as against 1.67% for unit trusts and OEICs.
Performance fees
Some funds charge a lower AMC but then levy a performance fee on top. The advantage of this is that the fund manager will earn more if they produce better results, while the investor is not penalised by poor performance (whether the fund manager makes money or not, he receives his management fee).
How charges affect investment performance
The higher the charge, the more an investor’s return will be affected.
An investor who owns a fund that grows by 6% each year for 20 years, and invests £10,000 at the outset of his investment, will see his fund value increase to a little over £32,000. Investing in a fund that produces the same rate of growth but is subject to the industry average TER of 1.67% would produce a final value a full £9,000 lower. In other words, nearly 50% of the total growth of the fund will have been paid out in charges.
Lower Costs make a compelling argument for investment trusts
With lower average AMC’s, and no up-front fees or commission to consider, the argument for investing in investment trusts rather than unit trusts or OEICs is fairly strong. However they are priced differently, and market forces can mean they trade at a discount to net asset values NAVs) whereas the price of unit trusts and OEICs will be at or around the NAV.
Whenever investing in any collective investment scheme, an investor should consider the costs of both dealing and initial investment as well as any ongoing charges that may impact investment return over the longer term.