They make you money and then they take a slice

Sam Dunn reports on the covert costs imposed on investors by managers of stock market funds and why, from tomorrow, they will be brought out into the open

You may well not know about it, but if you've got money in stock market funds, the people looking after your cash are gobbling it up.

Investors are often not given the full picture about something that can wipe hundreds of pounds from their returns - the true overall cost of managing their cash inside an equity individual savings account (ISA) or unit trust.

When trying to sell you funds, many salesmen and independent financial advisers (IFAs) usually just refer to an annual management charge (AMC). This is what you pay the manager to select stocks each year and make you money, and is separate from the one-off "upfront" charge levied when you first invest.

It can be as little as 0.1 per cent of your investment if you choose a tracker fund, which relies on computers simply to follow the movements of an index like the FTSE 100.

Or it can be as high as 1.75 per cent for an "actively managed" fund where humans use their expertise to try to "shoot the lights" out for performance.

So far, so simple. With the average AMC hovering around 1.3 per cent and assuming neither a gain nor a loss, a fund manager would charge £13 to run your £1,000 for one year.

But the expenses don't end there, for all funds incur a raft of "hidden annual costs", in the words of Justin Modray of IFA Bestinvest. "They include fees for legal work, share custody, trustee documents, auditing and administration." And these can add up to an alarmingly high total - in the worst cases, more than double the AMC itself (see the table above).

Fund managers have largely been unwilling to advertise this higher overall cost since it makes more of a dent in your returns. But the total expense ratio (TER), as it is known, is the figure you should ask the salesman or adviser about because it provides a much more reliable benchmark when comparing funds.

A lower TER indicates better, and more competitive, cost management.

"You should always look at the TER rather than the annual management charge - it's the bottom line," says Mr Modray.

If you're very lucky, the fund management firm will meet some of these extra costs but, in most cases, the company pays none at all. That leaves the investor footing the bill.

Say you invest £1,000 in a fund that grows in size by 7 per cent a year. It has an AMC of 1 per cent but a TER of 3 per cent.

After 10 years, your investment would be worth £1,791 if all you were paying was the AMC, according to research from Bestinvest. But tot up all the other costs to reach the TER, and you'd only have £1,480 - £311 less.

"Fund managers haven't wanted to show these higher costs [since] it puts them in a bad light," says Mr Modray.

However, things are about to change. From tomorrow, fund companies will, for the first time, have to inform you of this total cost of investing instead of just highlighting the AMC. They have been forced into doing so by a European directive that aims to make it easier for consumers to buy and sell funds. The TER must now appear in sales literature, usually known as a "Key Features" document, that is shown to you before you decide to invest your hard-earned cash.

"The arrival of the TER is great for ordinary investors as it's more transparent," says Ben Yearsley of IFA Hargreaves Lansdown. Costs will come down because, with investors able to see more clearly what different firms charge, fund managers will have to be more competitive, he says.

As a guide to value, the average TER for an equity fund that actively manages your cash is 1.57, according to Fitzrovia, a fund research company.

For investment trusts - rival savings vehicles - it is 1.25 per cent.

Bestinvest calculates that, for an index tracker, the average TER is around 0.35 per cent.

In particular, the new rules are expected to hit multi-manager funds that invest your cash in other funds - at an extra cost - adds Patrick Connolly of IFA John Scott & Partners. "Their AMC is often 1.5 per cent but, with the new TER rules, their published costs will be much higher."

Although fees are a key factor to check, they're only part of the story.

"Cheapest is not always best," says Mr Modray. "Over the last 10 years, Fidelity Special Situations [TER 1.67 per cent] has turned £1,000 into £4,620. The F&C FTSE All Share tracker (TER 0.35 per cent) has returned £2,000."

If you don't use an IFA, make sure you scrutinise every element - risk, past performance, overall fees - before making your choice on what fund to buy.