Don’t overpay for simple access to the stock market

Gas is gas. Whether it comes into your home from Ovo, British Gas or Eon, the actual stuff that gets piped into your home is the same. There’s no point paying more for it than you need to because you don’t get a better product at the end of the day.

That’s not true of everything you buy. If you purchase a top of the range gas cooker, you’re probably doing so because it’s got some extra hobs, or a second oven, or nowadays maybe even a touch screen display. Some items you might want to buy can de differentiated in terms of their quality. Others can’t, and so price becomes a big factor in your deliberations.

A similar contrast appears in the investment world, specifically when it comes to active and passive funds. An active fund is run by a professional fund manager who tries to beat the market. Like any profession, there are good and bad managers, so you can make a case for paying a higher annual charge for a top quality fund, though it doesn’t always work out that way. But in theory if you pay a fund manager an extra 0.3% per year in charges and they deliver a 3% return above the market each year, you’re quids in.

Passive funds, by contrast, track a particular part of the global stock market, often in a region like the UK, US or Europe. They are known for being cheap and cheerful, because they aim to simply match a stock market index by holding all the companies in it. For instance in the UK, most tracker funds follow the FTSE All Share Index, though some track the better known FTSE 100.

Within their particular regional buckets these funds all do a pretty similar job, give or take. You’d think, therefore, that the annual management charges for such funds were all much of a muchness, but you’d be wrong. For instance the most expensive fund tracking the UK stock market costs 20 times more than the cheapest! An investor with £10,000 in the most expensive UK stock market tracker pays £106 in investment management fees every year. They could cut that to as little as £5 in the cheapest tracker fund.

This matters hugely, because with a tracker fund, you’re not going to outperform the market, because you’re just following it. What you should get from your fund is the performance of the market minus charges. So the higher the charges you pay, the lower your annual return, and this compounds over time to diminish your nest egg.

Holding the cheapest UK tracker mentioned above could leave our hypothetical investor who started out with a £10,000 investment with a portfolio worth £19,580 after a decade, but just £17,807 if they invested in the priciest instead, a difference of nearly £1,800, assuming both funds deliver identical performance*.

The range of charges for passive funds that track the UK stock market is wider than those following markets in other regions. But a lot of investors in this country hold money in UK trackers because it’s our home market. As the table below shows, there’s a significant difference in other tracker fund markets too. We looked at a typical investor portfolio across these seven main investment sectors and calculated that an investor with £10,000 would be £900 better off after 10 years simply by switching from the most expensive tracker funds to the cheapest.

Source: AJ Bell/Morningstar

While some of the most expensive trackers may have first been purchased by investors some time ago and could originally have been priced with an ‘all-in’ fee covering investment, administration and any financial advice received at the time, it’s still the case that investors can cut charges and boost their wealth by rooting out costly trackers and replacing them with more competitively priced alternatives. As the figures above show, over time the compounding effect of even a small reduction in charges can deliver a sizeable boost to your nest egg.

*Assumed 7% investment return per year over 10 years. Figures compare investment return after charges from £10,000 held in the most expensive UK tracker vs. cheapest UK tracker fund.

**Assumed 7% investment return per year over 10 years. Figures compare investment return after charges from a £100,000 portfolio held in the most expensive vs. cheapest tracker funds. Portfolio split as follows, based on Investment Association FUM to approximate a typical portfolio mix: Asia Pac ex Jap 6%; Europe ex UK 11%; Global 31%; Global EM 6%; Japan 4%; North America 16%; UK 26%. Portfolio is worth £195,117.62 after 10 years in the cheapest funds, or £186,190.92 in the most expensive, a difference of £8,926.70.