Do investment charges matter?

Investment fund charges are back in the papers following the launch of the 'low cost' Fundsmith Equity Fund. To what extent do they matter?.

I was quite bemused to see press coverage at the weekend heralding the new 'low cost' Fundsmith Equity Fund, which charges 1% a year (plus an estimated 0.15-0.25% extra annual costs).

It's an interesting idea, but the 1% annual charge is simply due to the fund not charging the usual 0.5% trail commission when bought direct. This is a welcome move but, given the majority of funds are sold via third parties, Fundsmith's profit margin is probably not much different to most other fund managers.

And investors can buy most actively managed funds for around 1% a year by using discount brokers who rebate all trail commission (see our ISA Discounts Action Plan for more details).

However, this seems an opportune time to re-visit investment charges and ask to what extent they matter?

There seem to be two distinct camps when it comes to investment fund charges. Those who obsess, generally buying the cheapest funds they can find, and those (often financial advisers) who argue that performance is far more important. Actually, I suppose there's also a third - those who don't care or bother to check how much they're paying (the majority I suspect!).

I agree that performance after charges is what really matters. But without the aid of a crystal ball it's impossible to be certain about the future performance of a fund, so charges should be an important consideration when choosing investments.

Why it's hard to pick consistent winners

Over the last year 41% of active fund managers in the UK All Companies sector beat the FTSE All Share Index, the proportion falls to around 37% over 5 years. This is more or less on par with what you'd expect, after charges, if managers picked stocks at random - so it looks like the majority aren't adding value. And only 1 fund (SVM UK Growth) out of 205 beat the index in each of those 5 years (see more stats on our trackers page).

The reason I mention these figures is that they highlight the difficulty of picking consistent winners - an expensive top performer in the past could end up being an expensive failure in the future.

What difference can charges make?

Invest £10,000 into a fund with a 3% initial and 1.6% annual charge for 20 years and it'll be worth £23,394 assuming 6% annual growth. Sounds fairly impressive. But charges reduced the return by a whopping £8,678, i.e. your fund would have grown to £32,072 without charges - you can try more scenarios using our Fund Charges Impact Calculator.

So yes, they can make a big difference, especially over longer periods of time. Of course future performance can too but, unlike charges, it's an unknown quantity.

How much should I pay?

You should be able to avoid paying initial charges on most funds these days by using a discount broker, although the norm seems to be 3-5% for actively managed funds.

If you invest in a tracker fund and pay more than 0.5% a year then you're probably paying too much. There are exceptions, some niche indices might be more expensive, but when mainstream tracker funds like Virgin UK Index Tracking charge 1% a year it's well over the odds.

Actively managed stockmarket funds should come in at around 1.5% a year while corporate bond funds should be nearer 1%, although you'll probably end up paying an additional 0.1-0.2% a year via extra charges, so look at the total expense ratio (TER) figure which includes these. If the TER is more than 0.2% above the fund's annual management charge then be wary (read more about TERs & fund charges on our unit trusts page).

As previously mentioned, using a low cost discount broker who rebates trail commission should cut these annual charges by up to 0.5%, so it's quite possible to own actively managed funds for around 1% a year. Incidentally, in the above example this would increase your return after 20 years from £23,394 to £26,533.

Oh, and watch out for performance fees of about one fifth of all returns (on top of usual charges) that seem to be the norm for absolute return funds - way too high but sadly little alternative if you want this type of fund.

Do I need advice?

This is an important question as using a discount broker usually means having to make your own decisions. And there's a worrying trend amongst financial advisers to try and charge a 1% annual fee for their services (which I think is high), of which around half typically comes via trail commission.

With a bit of common sense I think most people have as much chance of choosing winning funds as an adviser. Even those companies who spend a lot of money and time researching funds still get it wrong sometimes.

But where a good adviser can add value is by ensuring a sensible spread of investment with good tax planning. For inexperienced investors this is valuable and the benefits will likely outweigh modest charges, but if you know what you're doing I'd be tempted to use a discount broker and pocket the commissions yourself.

Active or passive funds?

This is an age old debate and in my view there's no definitive answer - they both have their place. Take a look at our trackers page for more on this debate.

Conclusion

Don't ignore charges. Your first concern should be picking a decent investment that complements your existing portfolio. But then ensure charges are reasonable and in areas where active managers often struggle to beat the index then consider a low cost tracker, if available. And if you're comfortable choosing tax efficient investments and monitoring them yourself then use a discount broker who rebates trail commission.

Read this article at http://www.candidmoney.com/articles/article171.aspx