Active and passive investingWhat you need to knowCosts and chargesTheir key role in successful investing

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This guide has been produced for educational purposes only and should not be regarded as a substitute for investment advice. Vanguard Asset Management, Limited only gives information on products and services and does not give investment advice based on individual circumstances. If you have any questions related to your investment decision or the suitability or appropriateness for you of the products described in this document, please contact your financial adviser.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

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While no one can control what happens in financial markets, you can control how much you pay to invest in terms of costs and charges. They can have a significant long-term impact on the performance of your investment so it’s worth taking some time with your financial adviser to ensure you get the best deal.

This guide takes you through:

The role of costs and charges on long-term investing.

How costs compound over the long term, just like interest.

The role of costs in affecting fund manager’s performance.

The different types of fund manager charges and how fund managers deal with them.

Transaction costs and how fund managers can deal with them.

A handy checklist of questions to go through with your adviser.

From reading this guide, you will understand the different types of costs and charges that can affect your investments. You will also find out what kinds of questions to ask your adviser to make sure you get the best deal possible.

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3 The central role of costs and charges

4 The long-term power of costs

6 Costs and the zero sum game

8 Fund managers’ charges

10 Transaction costs

12 What next?

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The central role of costs and charges

Charges, taxes and other investment costs can significantly erode the value of your portfolio. A low-cost, tax-efficient portfolio can be the foundation for long-term investment success.

Costs matter

Never underestimate the importance of investment costs. Simply stated, they erode your investment returns. By keeping costs to a minimum, you improve your potential returns.

Charges typically include an Annual Management Charge (AMC) – this covers the fund manager’s costs of running a fund. Other ongoing administration charges may include audit fees, custody fees and other operational expenses. Together all of these costs make up the Ongoing Charges Figure (OCF) of a fund.

Most funds have a OCF of around 1-2%. Other charges sometimes also apply, such as an initial charge or a redemption charge. There can also be other hidden costs to look out for, as these too can affect the performance of your investment.

Annual Management Charge

(AMC)The AMC covers the fund manager’s costs of managing the fund. It typically does not include dealing costs or additional costs such as audit fees.

Ongoing Charges Figure (OCF)A figure for the total costs involved in managing and operating an investment fund. This includes the Annual Management Charge (AMC) which covers the fund manager’s own costs of managing the fund, as well as additional running costs, including administration fees, audit fees, custody fees and other operational expenses.

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Your financial adviser understands the nature of investment costs and can help ensure that your portfolio is as cost effective as possible. It is important to note that cost is not the only factor. This example assumes growth of 6%, however in reality returns may vary and you may get a lower return from a fund with higher investment costs.

The differences in fund charges can seem very small and you might think that paying 1.2% compared to 0.3% won’t make much of a difference. But because costs can compound, just like interest, over the long term, it can have a big impact.

How high fund costs can hurt over the long term

Using a hypothetical example (which does not represent any particular investment), the graph illustrates the potential impact of costs on a initial investment of £10,000 over a 30 year period. This graph assumes 6% average growth per annum which is compounded year on year. As this shows, a Ongoing Charges Figure (OCF) of 0.3% compared to a OCF of 1.2% could potentially lead to savings of £11,943 over a 30 year period.

The long-term power of costs

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Compound, compoundingRefers to when an asset generates returns which are reinvested and they generate their own earnings. In this way you are generating earnings from previous earnings. The compounding effect can be eroded by costs.

Growth of a £10,000 initial investment over a 30 year period,assuming 6% growth per annum

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 30

Years

Hyp

othe

tical

por

tfol

io v

alue

0.3% 0.6% 0.9% 1.2% Annual Management Charge

This hypothetical example assumes an investment of £10,000 over 30 years. Annual compounding is used for both the assumption of 6% average growth per year and the investment costs. Costs are applied to average annual growth of 6% for each year. As it is a hypothetical, this example does not represent any particular investment.

Source: Vanguard Asset Management

£0

£10,000

£20,000

£30,000

£40,000

£50,000

£60,000 £52,749

£40,806

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pound there is a losing one and if you subtract the winners from the losers you get to zero.

As a result, half of all pounds will automatically be on the losing side. Then, if you take account of costs – and if the theory holds – a majority of all pounds invested will fail to beat the market index whether that return is positive or negative. This happens because every asset manager starts out behind the index by the amount they take out of your investment in charges. They first have to beat the index by that amount just to break even. See our white paper The case for index fund investing in the UK for a discussion of the challenge fund managers face in beating the market.

A ‘zero sum’ game is one in which there are equal numbers of losers and winners. Investment markets can also be seen as a zero sum game until you add in costs. Then, there are more losers than winners!

Investments and the zero sum game

Any given investment market is a ‘zero-sum’ game. Academics use the term ‘zero sum’ to describe a game (or any other activity that can be counted) where the overall outcome always adds up to zero. Think of a game of poker where each player starts with a set amount in their pot. When they stop playing, whatever the outcome, the total amount that has been won by all players summed against the amount that has been lost by all players will be zero.

In terms of the investment markets, this simply means that relative to the total performance of the UK stock market for every winning invested

Costs and the zero sum game

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High costs and active management

Active managers face a significant handicap in the form of higher charges. Surveys of the average cost of active management show that total cost charge comes in at an average of 1.46% per year.* So the average active fund manager starts out 1.46% behind the index before they even begin to invest.

The total cost for the average index manager in the UK, on the other hand, is about 0.73%,* with some funds coming in significantly less expensive than that. Given that it’s so difficult for anyone to beat the index over longer periods such as five, ten or fifteen years, costs become a significant factor

when working with a financial adviser to make any investment decision.

Active investment management or actively managed funds An investment management approach where the manager selects securities from the investment universe in line with the fund’s investment objective. The aim of an actively managed fund is to beat, rather than simply match, the return from a particular market index or benchmark. A market index measures the performance of a particular sector or style of a securities market which is an example of a benchmark.

Index (passive) managementAn investment management approach that aims to closely match returns of a specified market index. An index fund may hold all the securities in the particular index or apply a mathematical model to purchase a sample of securities that will perform as closely as possible to the index. Also referred to as passive management.

*Source: Morningstar as at June 2015. Includes all funds registered for sale in the UK.

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How much a fund manager charges can have a significant impact on your investment over the long term. You might also want to ask questions about how they charge and whether it is transparent.

Fund managers’ charges

Annual Management Charge (AMC)

When you invest with any fund manager, you will have to pay some running costs. These include an Annual Management Charge (known as the AMC) which covers the fund manager’s costs of managing the fund over the year.

Additional running costs

With most managers you will also typically pay additional running costs out of your investment. These usually include administration fees, audit fees (where an independent auditor checks that all accounts are fair and honest), custody fees (paid to a custodian to safeguard the fund’s assets on behalf of the fund’s investors) and other operational expenses. The AMC, and these additional running costs, make up the fund’s Ongoing Charges Figure (OCF).

Look to see if a fund has a large difference between its AMC and OCF and ask your adviser about this.

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For more information on the role of the adviser and how to select one, please see the guide in this series title: Financial advisers: How they can help.

Commission, charges and advisers

Historically, many advisers received commission payments from fund providers and these were typically paid from a fund’s initial charge. However, following the Retail Distribution Review (or ‘RDR’), this practice has been stopped. If you don’t understand how you are paying for your adviser’s time and expertise, please ask them – they will be happy to explain their charging structure to you.

Initial charges and exit charges

You might see something called an ‘initial charge’ when you invest with some managers. This charge usually does not go back to the fund, it goes to the fund management company and forms part of its profit. Some managers also charge an exit fee when you want to leave their funds. You need to be aware of all of these charges before you invest.

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Transaction costs

In addition to a fund manager’s charges, there are a number of underlying costs that can hold back the performance of your investments.

How your investment is affected

When an investor enters or exits a fund, the fund manager has to buy or sell underlying securities on their behalf. Dealing in underlying securities such as an equity or bond, usually incurs transaction costs such as broker fees (the cost of buying or selling a security through brokers) and the bid-offer spread.

These costs can add up over time detracting from a fund’s potential returns. If the fund as a whole has to absorb those costs, then it affects every investor in the fund because those costs are subtracted from the value of their investment. In effect, all the fund’s investors are paying for an individual investor’s transaction.

Bid/offer spreadIn this context we’re referring to

the difference between the buying

and selling (or offer and bid) price

of an underlying security, such as

an equity or bond. The size of the

spread is affected by factors such as

current trading volumes and market conditions.

This works in the same way as

buying and selling currency when

you go on holiday. When you buy

currency, you buy it at a higher price

than someone who is selling that currency. The difference between

the two is how the bank makes

money on the service. Institutions

called ‘market makers’ do exactly the

same thing with equities or bonds.

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Stamp Duty Reserve Tax (SDRT)

Whenever UK equities are bought, or in some instances, when the shares of a UK fund investing in UK stocks are redeemed for in kind consideration, HM Revenue and Customs levies a tax called Stamp Duty Reserve Tax. This tax amounts to 0.50% of the value of the transaction, and applies whether the trade occurs in the UK or not. However, Vanguard assesses an entry fee of 0.40%* of the value of the transaction to the purchaser to cover the SDRT charge. SDRT is not a dealing charge imposed by the broker or fund manager but a self-assessed tax which applies to electronic or ‘paperless’ transactions only.

It is the industry norm in the UK for the fund to pay this tax for all transactions. This can sometimes be unfair as it

means that existing or long-term investors can be disadvantaged in the same way as other transaction costs. It’s worth asking your financial adviser how the fund manager they select deals with SDRT.

Finding transparent investments

Your adviser can locate those fund managers that deal transparently with transaction costs and make sure that long-term fund investors are not disadvantaged by the actions of others. This can be done using certain types of levies, such as a dilution levy or charging SDRT up front, in order to offset the transaction costs. These levies are returned to the fund for the benefit of the fund’s investors and aren’t kept by the fund manager.

Dilution levy As investors trade in and out of a fund, this can create expenses for the fund as the fund manager has to enter the markets to buy or sell the underlying securities. In order to cover these costs and ensure that existing investors don’t suffer, a dilution levy is applied to those specific investors, reflecting the value of these costs. The proceeds of the levy goes into the fund itself for the benefit of its investors and are not retained by the fund manager.

*The SDRT charge can sometimes be reduced by certain offsets. Vanguard calculated that an entry fee of 0.40% most closely represents the Funds’ new transaction costs.

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When you work with your financial adviser to build your investment portfolio you can ask about the fund costs and they can help you fully understand the cost of investing. The checklist of cost-related questions on the opposite page may help.

This guide covered• The role of costs and charges • How costs compound • Costs and investment returns• Different types of charges• Transaction costs

Your financial adviser can help

How much a fund management company charges you to manage your money, and how they deal with other costs and charges can have a significant impact on your investment. It’s worth spending some time with your financial adviser to understand how all these costs and charges work, to ensure you get a fair deal.

What next?

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Fund cost checklist

You might want to ask your adviser to run a simple costs checklist like this one:

Are all investment costs made clear and shown separately in the fund documentation?

Which investment costs will I pay up front and which are paid ongoing by the fund?

Is Stamp Duty Reserve Tax (where applicable) collected from the individual investor making the transaction, or the fund?

How are the fund’s long-term investors protected from the affect of other investors’ dealing costs?

Are the fund’s running costs paid for by the Annual Management Charge, or the fund?

Does the fund’s cost represent real value for money?

Connect with Vanguard™

Vanguard.co.ukClient Services 0800 408 2065

Important information

This guide is designed only for use by, and is directed only at persons resident in the UK. It is for educational purposes only. The information on this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2015 Vanguard Asset Management, Limited. All rights reserved. VAM-2015-05-22-2617

Please be aware that Vanguard Asset Management, Limited only gives information on our products. We cannot give advice based on individual circumstances. This is where the advice of a qualified financial adviser can be crucial. If you have any questions related to your investment decision or the suitability or appropriateness for you of the products or services described in this brochure, please contact your financial adviser.

Our Client Services team is available Monday to Friday from 09.00 to 17.00.