Investor beware as fees can often net more for manager of fund than returns

INVESTORS have been warned to check the charges they pay after new research revealed that hundreds of funds are making more in fees than they provide in returns.

Private investors have over 100 billion stuck in 260 funds that have charged more in fees over the past decade than they have produced in returns, according to research by DMP Financial. It analysed funds and investment trusts worth 100 million or more in the ten years to the end of November and picked out Friends Provident, Scottish Equitable and Scottish Widows among the biggest culprits.

The 493 million Friends Provident Monthly Distributor fund has returned -2.8 per cent a year in the last ten years, compared to an average for its sector of 1.7 per cent. Yet investors in the fund, which is bottom of its sector over both five and ten years, have paid about 4.5m a year in fees over the same period. DMP said fund management fees could only be justified where fund managers were adding value and urged investors to punish those that consistently fail to produce returns reflecting "market norms".

Graeme Forbes, chartered financial planner at Intelligent Capital in Glasgow, said many investors were ignorant of charges and their impact on returns. "People blindly choose funds heavily advertised in the Sunday papers based on advertised performance and not looking at returns after charges. Net returns are what matter, not headline growth rates," he said.

A lump sum investment of 10,000 over five years in a fund returning 7 per cent a year would be worth 14,000 if no charges were deducted. Introduce 2 per cent of annual charges into the equation, however, and that figure is trimmed to just over 12,600. But investors often allow the percentage figures for fees to obscure the long-term cost, said Chris Traulsen, director of fund research for Asia and Europe at Morningstar.

He continued: "The fact that it is reported as a percentage and that people focus on the short-term cost causes investors to focus a little less on fees than they should."

Even compounded charges at just 1 or 2 per cent can make a hefty dent in returns. A 1,000 lump sum investment 30 years ago growing at a rate of 6.5 per cent a year would be worth 6,600, if no charges were taken out. A charge of 1 per cent a year would reduce that fund to just 5,000, however, while a 2 per cent charge would slash it to just 3,750.

So what are investment charges composed of? The most regularly quoted figure is the annual management charge (AMC), usually about 1-1.5 per cent on unit trusts and Oeics (open-ended investment companies). Investment trusts and passive funds, such as trackers and exchange traded funds (ETFs), are cheaper, with annual charges generally 1 per cent or lower.

Paul Lothian, chartered financial planner at Verus Financial Planning in Dundee, called on fund managers to reduce AMCs as their funds grow in size, as they benefit from economies of scale. "What currently prevails is that their profits increase in direct proportion to their fund's growth – whether that is achieved by attracting new money or by growing assets, or both."

There are also the one-off initial charges, usually between 5 and 5.5 per cent on unit trusts and Oeics, but these are rarely levied on investment trusts. But investors are often advised to look for the total expense ratio (TER), comprised of the AMC and additional costs, including administration and custody fees.

The TER is the closest to a figure that reflects the real cost of the investment and tends to range between 1.6 and 3 per cent on unit trusts and averages 1.4 per cent on investment trusts, with several of the latter levying TERs below 0.5 per cent. But the total costs for actively-managed funds are generally higher than TERs indicate.

Lothian pointed to the difference between the performance of the FTSE All-Share and the returns enjoyed by investors. Between 1992 and 2003 the compound annual return in the FTSE was 8.99 per cent, but the average fund investor saw an equivalent return of just 4.91 per cent in the same period.

"This is a raw deal, explained partly by investment under- performance and partly by fund management expenses," said Lothian. "Most private investors are oblivious as to what they are paying and the effect that charges have, particularly over the longer term."

Then there are the hidden charges – commission, initial fees, stamp duty, marketing, turnover charges and other administration costs. Not only do they eat into returns, but they also can outstrip the TER, particularly in a fund doing a lot of trading.

Yet there is no evidence to suggest that paying higher fees secures better performance – in fact, the opposite is more likely to be true. Morningstar's research of US fund costs found that the average fund in the cheapest quintile a decade ago was twice as likely as the average fund in the most expensive quintile to outperform over the past ten years.