How to stop fund fees from eating your profits

Sunday October 15th 2006

Tim Hyam

Expatriates, it is often said, are in a privileged position as investors. Open before them is a huge range of investment funds based ?offshore? ? that is, in low-tax centres such as Luxembourg, the Channel Islands or the Cayman Islands. These offshore funds, which are valued at a total of $4 trillion, or one fifth of the world?s fund investments, also offer investors great benefits such as tax savings and stellar returns from assets and investment techniques that you won?t find in onshore markets.

Or so the story goes.

But what this seductive tale conceals is that investors are routinely charged more for offshore fund services compared with onshore, as reflected in fund managers? annual fees and other costs. The average total cost of an onshore fund based in the UK is 1.62% a year. Offshore the average is 2.09% but fees can be significantly higher, depending on the fund.

The effect of fees on investors? returns can be considerable. Take, for example, an onshore fund and an offshore fund that both bring gross returns of 7% a year. If the onshore fund has annual fees of 1.55%, it will bring you 5.45% net. The offshore fund has fees of 2.25% for the year and brings an annual return of 4.75%.

These differences build up significantly over time. A 7,000 fund investment growing for 10 years by 7% a year will grow to 13,770 gross. After the annual charges of 1.55%, the onshore fund will bring you 11,900, while the offshore fund charging 2.25% a year will bring you 11,134. This means that a difference of only 0.7 of a percentage point in annual fees has translated into a loss of 766, eating into or possibly cancelling out any higher returns or savings due to low offshore tax rates for the 10-year investment. Once you strip out the effects of inflation too, the total return can be even further eroded.

This is not to say that there are no benefits from putting your money into offshore funds. But before deciding whether to invest onshore or off, it is vital to be clear about what benefits, if any, going offshore will get you.

If current trends continue, offshore fund investing may well become the norm for UK investors as they face a dwindling pool of onshore vehicles to choose from. The Investment Management Association (IMA), the UK fund industry?s promotional body, says the UK is failing to attract new investment funds because managers are instead registering them in Luxumbourg, Ireland and elsewhere. The UK?s over complex tax regime is to blame, says the IMA.

If industry professionals prefer the more relaxed tax environment offered offshore, it is no wonder that many investors are also attracted by the tax regimes in offshore centres. For an expatriate who works abroad for many years and intends soon to retire to an offshore jurisdiction, offshore investment may lead to a significant extra rate of return.

But though offshore funds might not be taxed while the money is in the fund, the investor can become liable for tax when the money is repatriated. This means that for some expatriates who are working abroad for a short time before returning to a high-tax jurisdiction, the tax benefits of an offshore fund could be minimal.

Alternatively, the benefits of offshore funds may have nothing to do with tax. For some very rich investors who reside in high-tax countries such as the UK, other EU countries, the US or Japan, going offshore is all about access to extra returns. These investors focus on assets or vehicles that are forbidden by onshore regulations.

Paul Hamer, director at Jersey-based Advisa Offshore, says: ?Some offshore funds allow you to invest in assets without jumping through the hoops that you would have to under UK onshore regulations. But these funds tend to be for expert investors with at least 100,000 of liquid assets.?

Property, for example, is more accessible offshore, Hamer adds. ?There are only four or five UK onshore property unit trusts. Offshore, there are hundreds of property funds,? he says. This will change, however, when Real Estate Investment Trusts get the go-ahead to launch in the UK in January 2007. Commodities, derivatives and hedge funds are other asset classes that are more readily available offshore.

Whether you want to go to these tax havens in search of added returns from specialist assets depends on your appetite for risk. In a diversified portfolio it may be worth paying extra fees for one fund in hope of winning double-digit annual returns. To find the right solution it is always best to seek professional advice from an independent financial adviser, tax specialist or both.

Hamer says that some onshore funds perform better than offshore funds, and for some clients he advises that they have both onshore and offshore funds in their portfolio. ?We?ll do a risk assessment of the client and advise what suits them best,? he says.

Whatever investment portfolio you decide on, you should look for funds that publish their fees in the most transparent way, to make sure there are no hidden costs. Look for funds that publish their all-in fee, known as the ?total expense ratio? (TER).

The TER consists mainly of the manager's annual fee, but also includes the costs of other services paid for by the fund, such as the fees paid to the trustee or depositary, the custodian, auditors and the registrar.

TERs are typically between 1% and 2%. Large funds tend to have lower TERs than small funds, probably because of economies of scale, and funds investing in overseas markets have higher TERs than UK funds, owing to higher custody costs. Also, new funds tend to show higher TERs than old funds.

Many offshore funds in European centres such as Luxembourg and Dublin disclose their TER. In the UK onshore market, regulations require all funds to quote their TER.

Some funds have even moved beyond these ratios, and go out of their way to explain their fees to clients. Ed Moisson, director at fund analyst Lipper Fitzrovia, the independent firm that measures TERs, says: ?Some fund companies are actively justifying their funds' expense levels, comparing their funds to their peers. This in turn could move to a greater emphasis on value and not just a fund's pure cost ? linking expenses to other factors such as performance, risk and service.? This increased clarity about fees can only help investors maximise their returns.

Total Expense Ratio (TER) averages for UK and Offshore funds

Actively managed equity funds open to retail investors
All investment areas

Actively managed equity funds open to retail investors
Only funds investing in the UK

Offshore domiciles with funds in this analysis: Luxembourg, Dublin, Cayman, Guernsey, Liechtenstein, Jersey, British Virgin Islands, Isle of Man, Bermuda, Bahamas, Netherlands Antilles, Mauritius.

The asset-weighted average takes account of the fact that some funds with high fees have a low net asset value.

Source: Lipper Fitzrovia

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