Ways to build a low cost investment portfolio

Minimising costs is an easy way to assist long-term performance. Charges act as a drag on returns, and over time they can significantly reduce the size of your investment pot.

For instance, if you invest £100 per month for 10 years in a fund that achieves growth of 6% a year, your investment would be worth £16,388 at the end. However, increase charges by 0.5% a year and the sum falls to £15,951, and up them by 1% and it reduces to £15,528.

One way to reduce costs is through passive investments or ‘trackers’. These aim to replicate the performance of an index, say, the FTSE 100, rather than beat it. This is in contrast to active funds, which aim to outpace the market over the longer term. Often they don’t, though, partly because their fees are higher.

We believe there are pros and cons for both methods of investing. Charges are generally lower for passive funds, especially the competitive ones. They are also simple and transparent – you should get a similar return to the relevant market, albeit they usually end up marginally underperforming due to the charges, however small they are.

In contrast, active management can lead to a wider range of possible returns – potentially good if the manager gets things right, but also bad if they don’t. For those who prioritise cost, or simply don’t believe active managers can consistently outperform in a particular investment area, passive investing represents the potentially more appealing route.

There is no reason why you have to choose between the two. You could, for instance, use passives for part of your portfolio with some active funds populating other areas. Perhaps more specialist ones or where the manager has an interesting strategy or shown particular skill.

Low cost funds to consider

1. Passive funds

The market for passive or tracker funds, such as unit trusts and OEICs, following major indices is highly competitive. A number of fund ranges including those from Fidelity, Vanguard, Legal & General and BlackRock’s iShares have driven down the cost of investing.

If you have longstanding tracker funds in your portfolio it is worth checking the charges. Some older passive funds have relatively high annual charges, sometimes amounting to many times the cost of the ones listed above. Investors in these funds may wish to consider alternative investments as the relatively high charges could result in poorer returns over the longer term.

Read more: Active vs passive funds

2. Exchange-Traded Funds (ETFs)

ETFs offer further passive options ranging from conventional equity indices to esoteric ones such as individual countries or sectors. They are offered on virtually all asset classes and there’s over 1,700 available to UK investors. Unlike unit trust or OEIC funds that are priced once a day, ETFs are traded on the stock exchange, which means pricing is normally continuous during market hours.

For this reason they may appeal to shorter-term traders as well as investors with larger sums looking to track a given index for the long term. ETFs are designed to be low cost products, but it’s important to note that as well as the annual charge there are costs associated with dealing in shares – stockbroking commission, stamp duty and the ‘spread’ between buying and selling prices. Therefore they may be less cost effective than funds when dealing in smaller amounts. Major providers of ETFs include db X-trackers, ETF Securities, iShares and Vanguard.

The risks of ETFs vary significantly. Not only do they invest in all sorts of different areas, some of which can be exceptionally volatile, but they have a variety of different structures which makes it very important to understand what you are buying. In particular, those based on derivatives rather than physical holdings have additional risks.

Read more: How to invest in UK government bonds with an ETF

Which low cost funds are available on the Direct Investment Service?

There are a huge number of passive funds available covering a wide variety of markets, and even specific sectors. For those that are interested in constructing a low-cost passive portfolio our Direct Investment Service Preferred List provides some basic options in the major investment areas.

There are also 13 ETFs available on our Preferred List. Each offers simple, low-cost exposure to popular investment areas and has been selected for their transparency, low charges and typically narrow spreads – i.e. the difference between buying and selling prices.

Like all stock market investments, the value of an ETF will rise and fall and neither the capital nor income is guaranteed. All ETFs are linked to the value of an asset or index, but in times of market stress the value at which you can buy or sell may be different from that of the index. In addition, each ETF is exposed to a mixture of risks related to its asset class and method of investing.

The full details of the risks of a particular ETF can be found in the relevant Key Investor Information Document (KIID) and Simplified Prospectus. These can be found in the Key Features and Documents tab on the particular ETF’s page on our website.

Please note inclusion here does not imply a specific buy recommendation and past performance is not necessarily a guide to the future. The value of investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. Our usual charges apply to holding tracker funds on top of the fund’s own charge.

Please note: iShares Physical Gold is an ETC or ‘exchange traded commodity’, which aims to follow the price of a specified physical commodity, in this case gold bullion. ETCs therefore lack the diversification of ETFs as they concentrate on a single asset and can be higher risk.

Is your portfolio working hard enough for you?

If you are unsure of the level of risk you should be taking or which types of investments to consider, a consultation with a professional can help provide fresh insights going forward.

Find out more