Funds: Buy cheap, buy twice?

Fund charges are a huge point of contention in the world of investing. Let's imagine that there are two funds, Fund A and Fund B. Now let's say that they both invest in exactly the same stocks and shares. Yet Fund B is able to do it with an annual charge of 1% versus a charge of 1.5% from Fund A.

Now let's assume that both funds grow at a rate of 7% a year BEFORE charges and we invest £50,000 in each. The table below shows the compounding effect of higher fund charges over time.

	Value in Year 5	Value in Year 10	Value in Year 20	Value in Year 30
Fund A (1.5% annual charge)	£65,057	£84,649	£143,309	£242,621
Fund B (1% annual charge)	£66,706	£88,993	£158,398	£281,929
Difference in £	£1,649	£4,344	£15,089	£39,308
Extra % growth at end	2.53%	5.13%	10.53%	16.20%

 

As you can see the longer the timeframe the greater the compounding effect of higher charges. So it makes sense to keep costs as low as possible, especially when investing for the long term.

So should you just buy the cheapest funds?

Clearly the longer your investment timeframe the more influential costs become. But what about investors who have a 5 to 10 year timeframe, typical of many Stocks and Shares ISA investors?

To answer this I've analysed what would have happened if a DIY investor had based their investment choice purely on cost. To do this I decided to look at the biggest sector of funds, the UK All Companies sector in which there are over 249 funds.

I then looked at the ongoing charges figure (OCF) for every fund. I then divided them into 5 categories based on cost, each with the same number of funds.

1. Cheapest 20% of funds with OCF's of less than 1% p.a.
2. Funds with OCFs between 1% and 1.52%
3. Funds with OCFs between 1.52% and 1.63%
4. Funds with OCFs between 1.63% and 1.68%
5. Most expensive 20% of Funds with OCFs over 1.68% p.a.

I wanted to see what would have happened if an investor had invested on the basis of cost alone. Would they have been better off after 5 years? I looked at every possible 5 year timeframe since 2010 (assuming you invested at the start of a month) to see what would have happened.  That's a total of nearly 70 possible 5 year periods. The results are shown below:

Quintile based on cost	Average annual charge	Average total return after 5 years
1 (Cheapest)	0.60%	41.12%
2	1.22%	35.03%
3	1.59%	46.72%
4	1.66%	47.34%
5 (Most expensive)	1.81%	40.38%

Already this suggests that simply picking the cheapest funds won't boost your returns. However, if you pick the most expensive funds then your returns will be hit even after just five years. But there's an odd anomaly in the results. Clearly funds around 1.22% were the worst performers, but why is that?

The funds to avoid

The answer may lie in a separate unrelated piece of research I recently performed on the cost of Multi-Manager funds, also known as Funds of Funds (FoFs). These are funds that, rather than investing in stocks and shares directly, will invest in other funds instead.

The common view is that FoFs are expensive and often the national press will say as much. But what is the truth? I decided to find out.

There are 2,299 unit trusts out there of which there are 485 FoFs. If you analyse all their charges the average annual charge (OCF) of a FOF is 1.79% while a non-FOF  (i.e an ordinary fund) is just 1.35%. So it would appear that FOFs/multi-manager funds are more expensive in the main.

But there are two types of FOFs. Those known as 'fettered' FOFs which are comprised of the investment house's own funds. Think of it like Tesco making a shopping basket full of it's own labelled foods.

Then there are 'unfettered' FOFs which comprise of funds from anywhere. Think of this like Tesco making a shopping basket which contains its own labelled foods as well as branded goods such as kelloggs cornflakes.

Now the average cost of an unfettered FOF is 1.87%. So it is the most expensive type of fund as there is duplication of charges as every fund within it has it's own charges. But the average fettered FOFs charge is just 1.24%!

So to sum that up in a list from cheapest to most expensive:

• average annual charge for a fettered multi-manager fund is 1.24%
• average annual charge for a non multi-manager fund (i.e. an ordinary fund) is 1.35%
• average annual charge for an unfettered multi-manager fund is 1.87%

So this goes totally against what the national press will have you believe. The reason why a fund house can make a cheap multi-manager fund when they use their own fund to build it is that they can reduce their margins. Just like Tesco can when they build a basket full of their own labelled products. Why make them so cheap? To encourage investors to buy them!

However, if you can only make up a fund out of a shortlist of your own small selection of in-house funds the potential to outperform is restricted. The FoF manager may only have a couple of equity funds to choose from and if these are not performing well then there's not much they can do about it!. So going back to the table at the top of the article. Those funds that underperfomed the most had an average annual charge of 1.22% which is almost exactly the same as the average fettered FoF. Interestingly the most expensive funds have an ongoing charge of 1.81% which is what an unfettered FoF charges. Now this may be coincidence but it may surprise you that there are fund of funds (fettered and unfettered) within the UK All Companies sector.

Costs are important but not the most important thing

So if you buy a fund based purely on cost the chances are that you won't improve your returns, in fact you are likely to worsen them. Don't forget the original example with Funds A and Fund B is contrived. In reality no two funds are identical so their performance can vary hugely which can offset any positive or negative effects of the fund's charging structure.

That is why all performance figures on 80-20 Investor are quoted NET of charges as performance is more important.

What should you do?

Looking at the above table of returns versus the fund charge you can see that by just increasing the fund charge by fractions of a percent can push you into the more expensive category and impact your returns. So keeping costs to a reasonable level, well below 2% is important. Yet now imagine that you are not a DIY investor and have a financial adviser who is taking up to 1% of your portfolio as well each year. Then there is the investment platform you use which will take another 0.25% say. You can see that these mount up and would then destroy your returns not just over the long term but also the short term.

The important thing to do is reduce these charges or eradicate them altogether. It will have a much greater impact than tinkering around the edges with fund charges. As an 80-20 Investor member you are probably not paying a financial adviser an ongoing percentage of your portfolio each year. In fact it's probably part of the reason why you decided to run your own money!

Make sure your investments are held with the cheapest investment platform based on the size of your portfolio, which preferably charges a fixed fee rather than a percentage of your portfolio. You can see full analysis of which investment platform would be the cheapest for you here.

A far more reliable investment process remains using the momentum strategy at the heart of the 80-20 Investor algorithm and ignoring fund charges altogether. If you perform the same analysis as above over the same period of time your average 5 year return would have been 101.57%!

 

 

 

(image by by Stuart Miles via freedigitalphotos.net)

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