Find the hidden costs in your investment fund

New guidelines are encouraging some investment fund providers to disclose more of the costs we pay, which makes it easier for us to pick which are most likely to be the top performers.

Study after study has shown one way is by far the best when it comes to predicting how successful your investment funds will be, compared to other similar funds and the overall, relevant investment market itself.

And that one way is to compare costs. The lower the costs, the more likely the fund is to outperform similar funds.

Some of the key costs

You should easily find any fund's annual management fee and some operational expenses, both of which are summarised neatly in an 'ongoing charges figure' (OCF) or in the outgoing 'total expense ratio' (TER), which is usually near identical.

Initial charges are also clearly shown, as are performance fees.

There are other costs for those who are buying or selling units in a fund that are usually shown, though they are not always easy to find. These are the fund-price spread and/or the dilution levy, which are (rather imperfect) ways reduce the cost impact on long-term investors of those buying and selling fund units quickly.

Look to the fund documentation or to fund-comparison sites for all this cost information.

The hidden costs

However, the information you get on costs tends to dry up here – even though there are many more, which eat away at any gains your investment fund makes (or increase your losses).

These costs are hidden in the performance of the fund, rather than revealed in the OCF or some other figure. They include the costs to existing investors when the fund manager buys and sells assets in the fund, the fund's debt interest charges, and up to a dozen or so other items.

The effect of these costs

Say you have a fund with an OCF of 0.7%pa and no initial fee. If it has reasonably low hidden costs of 0.5% and you invest £100pm, increasing with inflation, you might make nominal gains of about £9,800 in 20 years (assuming a return of 4% per year before these costs, and 3% inflation). If your hidden costs are 1.5%, your gains will be more like £5,900, or 40% less.

New disclosure is helping

Some firms have begun to disclose some more costs on their websites, under the encouragement of the Investment Management Association (IMA), which can see which way the wind is blowing. See if your fund provider is doing so here.

Legal & General has been more transparent than most companies for some time now, but it has also taken up the IMA's suggestion to disclose more on a single webpage, which clearly shows some of L&G's previously hidden costs.

The page lists its funds in one table, along with some of the most important hidden costs, shown as a percentage of your investment:

• Average stockbroker fees and commissions over a three-year period. This is one of the costs the fund manager pays to middlemen to trade investments in your fund, and it usually applies to shares only.
• Average transfer taxes over a three-year period. This includes Stamp Duty Reserve Tax (SDRT) and other transfer taxes (e.g. paid to other countries) that the fund has paid through the broker as a result of buying certain investments.
• SDRT paid directly by the fund over the last financial year. If one investor buys units in the fund and another sells, the fund can transfer the holdings directly to the new investor without selling and re-buying the underlying investments. Currently, the fund still has to pay SDRT for this on the new investor's behalf, which the manager pays monthly, directly to Revenue and Customs. This second layer of SDRT is being abolished from April 2014, which will probably have a significant impact on many fund investors' returns.
• The dealing spread for buying the fund's underlying assets. When the fund buys and sells assets on your behalf, it has to pay slightly more than they're worth to buy and it receives slightly less when it sells, rather like when you buy and sell foreign currency and you don't get the “real” exchange rate. (This spread is in addition to broker fees, in the case of shares.)

Unfortunately, the table just shows the dealing spread on one day of the year, not an average, so it's surely very inaccurate.

These costs will vary each year, possibly more than the OCF does, but you can still add them to your OCF to get a better idea of your total costs.

Still more hidden costs

Legal and General has presented this information more clearly and completely than others who are following the new guidelines.

Unfortunately, there are yet more hidden costs and risks about which you can't find any details anywhere, and investment funds' long-form accounts contain many question marks, some of which even Legal and General didn't answer for me. These questions, costs and risks are usually less important than the hidden charges outlined above, but there are occasions when they could be essential.

The industry is walking towards full disclosure though, so hopefully we'll see more movement on this soon.

Costs aren't everything

Cost is one of four main factors to consider when choosing where to put your money. The other three are:

1. Be invested in the right sort of assets for your goals and your tolerance of short-term meltdowns. This might mean you're in shares and perhaps peer-to-peer lending if you're investing for the long-term, but potentially more of a mix of assets (such as shares and cash, or shares and bonds) as you get nearer to selling a lot of your investments.

2. Where there are greater risks, such as political risk and corporate corruption, particularly in frontier markets, most people should generally stay away or at least invest smaller amounts.

3. The vast majority of us should have diverse investments. You don't want to be investing all your money in just one actively-managed fund, although one cheap fund that tracks the FTSE All-Share index could well provide ample diversity for many long-term, regular investors.

You should research those areas as much as you do costs.

Notice that past performance doesn't make the list. Mountains of research over the past few decades shows that a fund's performance over one, three or five years is an absolutely dreadful factor to use when choosing a fund. Ten years of the fund manager's performance might be better, but I've seen few good, independent studies on that and they present a mixed bag of results.

If picking fantastic funds was that easy, we'd all be rich.

More on investing:

New funds with no annual management charges

Crowdfunding: how to invest in start-ups with as little as £10

New investment calculator could save you thousands

DIY investors hit by high exit fees

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