Understanding charges involved with Child Trust Funds

Among the issues that need to be considered by parents as they choose Child Trust Funds (CTFs) for their kids is that of charges. At one level, it is hard to see why it should: after all, isn't fund performance what really matters? Why whinge about how much a fund manager gets if his or her skills can deliver extra growth to the value of your fund?

These questions - and the standard replies to them - will undoubtedly dominate the thinking of millions of parents. Yet dig below the surface and the important role of charges in a fund's total returns becomes interesting.

Do charges affect performance?
Take a simple example: when you buy into a CTF, especially a share-based one, there is a possibility that you may face an initial charge on your investment.

For unit trusts this tends to be about 3% to 6%, depending on the fund manager. What this means is that your £100 a month, assuming that's what you pay in, automatically becomes anything from £94 to £97 before the fund manager even waves a magic wand over it.

Thankfully, many of the CTFs sold will be so-called stakeholder ones, which have no initial charge and a maximum levy of 1.5% a year. Some have already announced that they will charge less, in the region of 1%, while others will go for the full amount they are entitled to under stakeholder rules.

To the uninitiated, the difference between 1% and 1.5% sounds small. Until you add up the effect over time. Say you are investing over 18 years. That 0.5% difference will mean that at the end of the investment period whoever paid 1.5% will receive 9% less than the person who stayed with the "cheaper" provider.

Imagine the effect of that on a CTF which grows to £25,000: the difference becomes a whopping £2,250.

Why you should pay more
The basic argument is: you get what you pay for. At the end of the day, some fund management companies charge more for their skills so that they can use the money to hire the best analysts, motivate them properly and provide them with the best resources they need to do their jobs.

Why you should pay less
The only way you will know if an expensive charge is justified when, after a given number of years, it is possible to demonstrate that better returns have consistently been delivered by companies that charge more.

Yet back in 2002, a government-backed report into the retail savings market by Ron Sandler, former chief executive of Lloyd's insurance market, found that: "The average UK unit trust underperformed the market by 2.5% per year due to a combination of charges and unsuccessful active management.

"Correlation between higher charges for unit trusts and superior investment performance is at best weak. Consumers who pay more usually receive no additional benefit."

A report by The WM Company- the research subsidiary of Deutsche Bank - in February 2003 showed that over the past 20 years, 79% of active funds failed to beat the benchmark FTSE All Share Index.

The importance of the above date is that it includes most - if not all - of the period in which markets have fallen since March 1999. Trackers are generally reckoned to do worse in falling markets because top managers can "stock-pick" their way to better performance.

What charges are applied?
With stakeholder CTFs, the total annual charge is a maximum of 1.5%. However, for share-based CTFs, in addition to the management charge, there may be additional costs. These can include:

• Trustee fees
• Audit costs
• Administration fees
• Sales and other transaction fees, stockbroker's costs and any interest costs

These are not generally included in a fund's annual management charge and form part of what is known as the "total expense ratio", or TER.

What you can do
Before you invest, make sure you know exactly what the charges are on the fund before you place your money in it.

The danger is that if you decide, further down the track, to switch out of an under-performing fund, you will get back less, because the manager will levy some of that TER to sell up your investment.

Finally
Don't assume that just because a building society-style cash CTF has no formal charges that you aren't paying a fee here. It is, in effect, disguised in the interest rate you receive from that account. A lower rate means higher charges and - potentially - higher profits for the institution offering that account.