Small differences in fund manager charges can have a huge impact on investment returns, which is why the debate on fund charges versus fund performance is set to continue
Choosing a collective investment fund for a client can be a daunting prospect. There are currently around 3,000 onshore and offshore unit trusts, open-ended investment companies (Oeics) and investment trusts available.
Consumer press and media stories abound with accusations that high charges always produce poor performance. Some clients are so wrapped up in this 'charges versus performance' issue that they are becoming increasingly difficult to advise.
The term 'cost drag' has become the in-vogue phrase for many potential collective fund investors, and it is easy to see why. On the back of recent world stock market volatility, and with lower equity returns being predicted for some time ahead, many investors will have concerns about fund management charges eroding their investment performance.
It is clear that, in general, high fund charges do impact on performance, especially when they are compounded over a long period. So does that mean we should try to buy investment funds for our clients as cheaply as possible, or is there a hidden danger if the public are encouraged to choose investments solely on the basis of price? Does cheaper necessarily mean better when it comes to investment fund choice?
Is cheap best?
As most investment advisers know, collective investment funds come in two main types: the traditional unit trust and the Oeic. The two are broadly the same type of fund, with the main difference being that an Oeic is bought and sold at a single price whereas a unit trust has a bid-offer spread, typically around 5% of the initial sum invested. On an ongoing basis, the fund manager makes an annual management charge, usually between 1.25% and 1.75%, and there may be other charges for switches and other administration-based costs.
But what effect do these charges have? Surely the odd 1% charge here and there will not make a huge difference to the potential returns from an investment fund? Actually it will. Small differences in charges can have a huge impact on returns.
For example, consider a fund that grows at 10% a year for 20 years and compare it to one that grows at 8.5% a year. Although the differential between the two rates of return is just 1.5%, the 10% fund would actually return 24% more than the fund that grows at 8.5%. High initial charges will compound the reduction in performance and, if you tend to advise your client to switch their funds regularly, the charges for doing so will also take their toll.
Huge amounts of research have been carried out on whether past performance really is a good indicator of future returns.
Wish upon a star
So, should you buy a fund just because it has done well in the past? The popular answer is no, which in reality is odd, because many advisers admit to choosing funds on the basis of past performance and a good track record.
Can any adviser say with complete honesty, that they have never been influenced by some of the stunning past performance statistics that feature so prominently in fund advertisements? It is clear some adverts within the popular consumer press could certainly be accused of being somewhat selective about how they present information on charges and performance. It is very easy to flatter the true performance of a fund.
Although the FSA would not approve of me saying this, sometimes good past performance is an appropriate guide to the prospect of good future returns, but in equally as many cases, it is not.
So, should we follow the star fund managers? That has to be a safe bet in justifying higher charges. After all, many of your clients would have heard of Anthony Bolton. Surely if we select a particularly successful manager they will accept they are simply paying for his remarkable services? Or is picking a fund just because of a star fund manager also full of potential pitfalls? After all, the star manager can always have a poor year, take a sabbatical, retire or even move over to another fund.
Clearly, star fund managers and star funds do both have their place in the overall process of fund selection. While the fund supermarkets can often negotiate substantial discounts in fund charges, the very best funds will still be reluctant to discount heavily. After all, investment houses are not daft. If they have a fund with a superb track record of performance, the chances are an adviser's clients will have to pay higher initial charges and annual management charges to get in on the action. In short, if they know investors want their product, they can charge whatever they think they will pay.
In my opinion, charges should only be a major driver in decision-making when faced with a choice of two similar funds with similar performance over the same period of time. Otherwise, there is a real danger that concentrating on cost rather than overall value could compromise investment returns over the longer term.
Value for money
It should be remembered that the main purpose of collective investment funds (particularly offshore funds) is for domestic investors to gain access to markets that would otherwise be hard for them to reach.
This is where specialist collective investment fund management can really come into its own field. A good example is emerging markets, such as Latin America or China, and other areas where it would be difficult for the average investor to adopt a do-it-yourself approach.
Most major collective fund managers certainly don't simply follow the latest investment trends. Many firms employ large numbers of researchers and analysts all over the world, who are constantly searching for companies and markets that have the potential to provide real opportunities. This specialist knowledge and research comes at a price and, like most things in life, you only get what you pay for. The costs of such a large operational infrastructure and resource will be reflected in higher fund management charges for the investor.
A key example of this is Fidelity. No adviser could argue the credentials of this leading investment management group. Indeed, Fidelity International was named as Fund Group of the Decade at the Investment Week Awards in 2005. Equally, Fidelity would probably be the first to agree that its fund charges are by no means the lowest in the marketplace and when Fidelity conducted some research into the performance of its funds, the results were quite surprising.
Its research considered the relationship between charges and performance in the investment market as a whole. It looked at the 10-year returns from a number of funds with a range of annual management charges, investing in six key regional sectors, UK All Companies, Europe (ex-UK), North America, Global Growth, Japan and Far East (ex-Japan).
The results showed that, even after the deduction of charges, the returns from funds with higher charges were significantly better than those with lower charges. Indeed, without wishing to sound like an advert for Fidelity, the majority of its funds consistently beat its relevant benchmark index.
If one considers the returns from Fidelity's UK-domiciled funds over the five-year periods ending each month between January 1998 and January 2005, in 82% of cases, Fidelity's performance was better than the benchmark index. Yet, those same Fidelity funds all feature what can only be described as higher than average charges.
Of the three original Fidelity funds launched in 1980, two have the best performance records out of 200 mutual funds available to UK advisers to date. If you had invested £10,000 in both of them at launch, you would now have £958,976 in the Fidelity Special Situations fund and £542,045 in the Fidelity American fund, (after the full initial and ongoing management charges are taken into consideration). Again, the charges for both of these funds could not be described as low in relation to the average for the sectors.
So what can be concluded from all of this? In reality, not much. Just as there are funds with high charges that are easily justified, there will still be funds that have high charges and poor performance.When selecting an investment fund for your client, don't concentrate just on charges, historic performance or the track record of the fund manager. Look at all of these factors together, then start your research all over again and add in correlation, risk, and volatility.key points
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