You should reasonably expect to be charged a fee for the services of a professional fund management company, especially if that firm is doing a good job of making your money grow. Unfortunately, there are a great many funds out there, which don’t provide the kind of performance their investors might expect, but which nonetheless charge a fee for the service. In fact, they don’t charge just one fee, they charge a variety of them. Entry fees, exit fees, performance fees, annual management charges, transaction fees, the list goes on. The inclusion of one or several of these fees over the life of an investment can make a huge dent in the overall return to the investor.

The frustrating aspect from the buyer’s point of view is that there is no consistency in the charges levied by fund managers. This problem was recently highlighted by Standard & Poor’s in their study of fund fees. According to S&P: “we have found that there is often no correlation between fees, volatility and historic returns. In theory, the riskiest sectors, which offer the best likelihood of returns, could potentially justify the highest fees. And this is certainly true if we look at broad sector categories: equity sectors tend to be riskier and have higher management fees than fixed income sectors.

The harsh reality is that fund management companies can afford a degree of complacency, because they get paid whether they make money for you or not. That is why fund manager selection is so important.

Here is a break down of the most common types of fund fee:

  • Management Expense Ratio (MER). Marketing, sales, administration, legal, accounting, reporting and portfolio management costs are charged directly to the fund, and reduce the value of your investment; the MER reflects these costs.MER values range according to the cost of managing each fund, but a maximum MER must be specified in the simplified prospectus of the fund. While 1-5% may seem like a small price to pay, remember that a fee increase of just 1% (from 1-2%) on a $10,000 investment earning 8% annually can reduce the value of the investment by more than $5,000 over 20 years.
  • Sales fees are somewhat flexible, in that you have a choice of the type of sales charges you pay. Front end load fees are charged against your initial investment as a percentage, and often go towards paying financial advisers. You may be able to negotiate these fees and many financial advisers will make a point of rebating part of all of their commission to the client.
  • Deferred charges, also called exit fees or redemption fees, are deducted from your investment if you cash in before a certain time period. These fees decline each year that you hold the investment. Deferred sales charges are paid to the fund management company, and some companies allow you to make partial withdrawals without paying these fees. Again, some fund companies use the deferred sales charge as a way of paying introducers.

Some funds charge up to 5% in initial fees and 2% or more in annual fees. Unless the manager is exceptionally good, this level of charging is hard to justify. There is surprisingly little variation in costs between one fund and another, and investors can easily pay the same charges for a top-performing as one at the bottom of the pile. A survey in specialist UK magazine Money Management, shows the average annual charge on the bottom 20 performers in any investment sector is much the same as, or sometimes more than, that in the top 20.

In the equity income sector, for example, the top 20 funds charge 1.5 per cent a year on average, while the bottom 20 charge 1.6 per cent. The difference in performance is much more striking: an average gain of 9.6 per cent over the three years to March 26 2004 for the top 20 against a loss of 13.8 per cent for the bottom 20.

The problem for investors is they can only judge whether their investments provided value for money with hindsight. Managers do not rebate any charges if they perform badly

It’s easy to assume that the odd 1% here and there doesn’t make much difference. But this is definitely not the case. A fund that grows at 10% a year for 20 years will give you 24% more as a final sum than a fund that grows at just 8.5%. Initial charges can quickly take their toll, especially if you tend to switch funds every few years.

And while initial fees can be reduced or rebated, there is rarely any discounting of annual management charges, and most investors are probably unaware of what they pay in total annual costs as fund managers have not been required to reveal the information.

The annual management charge is usually by far the biggest element of the total expense ratio (TER), which is a measure of the total annual charges on a fund. But additional costs, such as the fees paid to the trustee (or depositary), custodian, auditors and registrar, can add anything between 0.1 and 1.9 percentage points to the management charge. So an annual management charge can easily jump from a published fee of 1.5% to a TER of 2.5%.

The additional costs are typically fixed rather than being charged on a percentage basis, so the bigger the fund, the smaller they will appear as a proportion. It is generally considered that to keep total expenses to investors at a reasonable level, a fund must have approximately $10 million under management.

In a low inflation world, charges like these take a huge bite out of your capital. And worse still, there is no real correlation between funds with higher than average charges and funds with better than average performance.

However, don’t get too obsessed about charges – choosing a good performing fund for the medium to long term is much more important – the main criteria for choosing any fund manager should be their ability to produce consistent positive returns. It is important to note, for example, that low cost doesn’t equate with quality. It’s easy to be fooled by attention grabbing headline figures and advertising claims like ‘no charge’ – but this usually just refers to the initial charge. It’s worthwhile looking at all the charges in detail because, over the long-term, annual charges and other expenses can have a more significant effect on your fund’s performance than the one-off initial charge.

Jack Bogle, founder of the US index fund giant Vanguard, is one of the highest profile opponents of fixed fees to investors in funds. He says: “Management fees in this industry run about 1.6% for the average equity fund. By the time you add in portfolio turnover costs, which nobody discloses, and you add the impact of sales charges and opportunity costs because funds aren’t fully invested, and out-of-pocket fees, you are probably talking about another 1.4% of cost, bringing that 1.6% management fee or expense ratio up to 3% a year. That is an awful lot of money.

In other words, the average mutual fund has to earn 3% a year just to break even.

And the fund management industry wants to keep you in the dark. The US mutual fund industry is the biggest in the world, and is used by many millions of Americans to fund their retirement savings through employer-sponsored 401k investment plans. At year-end 2000, over $4.5 trillion was invested in open-end equity and bond mutual funds and another $1.5 trillion in money market mutual funds according to data published by the Federal Reserve. Seven years ago, a survey by market regulator the SEC (Securities & Exchange Commission) revealed that four out of five investors had no idea how much they were paying in fund fees. A study carried out in 2000 proposed tough disclosure rules. Funds industry representative body the ICI (Investment Company Institute) vehemently objected to these disclosure rules. Since then, the SEC has taken no action, despite the recent trading scandals involving some of the biggest names in global fund management.

Further reading:
SEC Report on Fund Fees – www.sec.gov

The Fund Fees You Don’t See – www.fool.com

Comparative tables of returns and charges – www.fsa.gov.uk

Want to invest in a range of different funds at a discount?
Click here: www.offshorerebates.com

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