What a waste: fees cost investors £6bn

In a hostile market environment, investors cannot afford to be wasteful. Which is why anyone who is considering buying an individual savings account (ISA), or making any other sort of stock market investment in the near future, should take a look at the following figure: over the past decade, investors have together wasted more than £6bn in initial charges on investment funds. This frightening statistic comes from Lipper, a group specialising in investment fund analysis, on behalf of Virgin.

In a hostile market environment, investors cannot afford to be wasteful. Which is why anyone who is considering buying an individual savings account (ISA), or making any other sort of stock market investment in the near future, should take a look at the following figure: over the past decade, investors have together wasted more than £6bn in initial charges on investment funds. This frightening statistic comes from Lipper, a group specialising in investment fund analysis, on behalf of Virgin.

Lipper shows that the average initial charge on an investment is 3.94 per cent - greater than any one-day fall in the UK market over the past 10 years. The research states: "Paying an initial charge is, in effect, voluntarily accepting that your savings are going to suffer the equivalent of the biggest market decline in a decade on day one of your investment."

The drawback with high initial charges is not the fact that if you invest £1,000, you have to pay an average of £39.40. For most investors, this won't break the bank. The point is, that £39.40 will grow considerably in value over time. If you invested £39.40 in 1980, say, it would now have grown to £1,046.

Despite the impact of charges on the performance of an investment fund, relatively few investors take steps to reduce or avoid upfront fees. In fact, research carried out by a separate group, Taylor Nelson Sofres, found that even among experienced investors, around 70 per cent were unaware they could act to cut the initial fee.

Avoiding initial charges is not simply a matter of buying a tracker fund, though this is one way round the problem. Tracker funds mimic the performance of a stock market index by buying up stocks in the exact proportion in which they are held in the index. Since this is done by computer, rather than a management team, trackers do not charge initial fees. Their annual fees are also low, averaging less than 1 per cent, while actively managed funds tend to charge 1.5 per cent per year.

But Jason Hollands, deputy managing director at Bestinvest, the independent financial adviser, says investors should not focus too much on initial charges. "Fees have an impact over time, but you have to look at fees in totality. The formula we use is the reduction in yield [RIY], which takes initial and annual fees into account." All ISAs are required to include the RIY in their key features.

Mr Hollands points out that although index-tracking funds offered by Virgin and Legal & General both have no initial fee, Virgin charges a 1 per cent annual management fee, while L&G's is 0.5 per cent. He says: "Relatively speaking, Virgin's fund is one of the most expensive of its kind."

Many investors have become wary of tracker funds. When the market is falling, there is little advantage in buying a fund which mirrors that poor performance. However, picking a fund which outperforms market indices year after year is not an easy task. Groups which sell index trackers, such as Virgin and Legal & General, point out that over time your money is likely to perform just as well, if not better, in an index-tracking fund.

The active versus passive fund-management debate has been raging for many years and is unlikely to be settled definitively now. But those in the active camp have another weapon on their side: it is possible to pay low charges yet still benefit from active fund management. The best way of doing this is to buy a fund through a fund supermarket or discount broker. The two main fund supermarkets - Fidelity's FundsNetwork and Cofunds - both offer significant discounts off the initial fee.

You can buy your fund direct from FundsNetwork, while Cofunds is only available through intermediaries. And it is by going through an intermediary that you will find the best bargains. For example, if you buy the Invesco GT European Smaller Companies fund direct from the fund manager, you will pay an upfront fee of 5.25 per cent. If you buy it direct from FundsNetwork, you will pay just 1.5 per cent. However, if you buy the fund from Bestinvest, through Funds-Network, there is no initial fee at all.

Buying your fund through a supermarket is relatively hassle free - and bizarrely, there is no catch. Supermarkets do not levy any extra charges; they receive their money from fund managers as compensation for simplifying their administration.

Many discount brokers also offer to rebate some or all of the initial charge to the customer, making investing much cheaper in the early stages of the investment.

However, when buying a fund, do not necessarily opt for the one with the lowest initial charge or the greatest discount. If annual fees are high, you will end up curtailing your investment performance - particularly if you intend to hold the fund for several years.