Max Home: Making the most of fund management is no joke

AN OLD music hall joke asks "How do you make a small fortune using a stockbroker?" The punchline: "By starting with a large one."

Is active fund management worth the cost? Most investors are looking for the highest possible returns with the least risk but all this comes at a cost. At one end of the scale we have discretionary fund management which makes daily trades to maximise returns. We also have discretionary fund managers that will operate within your own parameters to maximise investment but again this comes at a cost.

Many financial advisers operate a model of active fund management where they will create a portfolio of funds, whether through unit trusts or open-ended investment companies, and monitor them regularly and make changes where funds should be held, sold or new ones bought. All funds need to publish a total expense ratio as to their costs but this does not tell the full story.

Justin Urquhart-Stewart, the marketing director of 7 Investment Management, is on record as saying that Britain is in a crazy situation, in that for most funds we do not know the actual costs of investing as there are hidden costs including the cost of trading within those funds which are on top of the stated charges. A fund that trades heavily, for example, will be high-cost and could cost about 50 per cent more than one that does not alter its holdings regularly.

The alternative is passive fund management. What this does is create an index, tracker or exchange-traded fund (ETF) method used by some firms to create their own index to broadly replicate the sector invested in. These funds will only make changes if weightings change, or for example, if a stock falls out the FTSE 100.

The cost of using these passive funds is relatively low as there is little fund management required. The big argument for using passive fund management is research by Standard and Poors in the US, which shows that 72 per cent of large cap fund managers did not beat the index from 2004 to 2008. The figure for mid caps is 79 per cent and for small caps 85.5 per cent. Evidence shows a similar experience in the UK.

So why pay for active fund management when the evidence indicates it may not work? The answer could lie in a combination, using what is known as a "core and a satellite" approach, where the core, perhaps up to 80 or 90 per cent, would be invested passively with the balance invested actively and changes made accordingly, to capture performance. If you can do this and save about 1 or 2 per cent in fund management charges, the value of an investment can mount up significantly over ten or 20 years.

My own preference is core and satellite, investing the bulk of funds passively with a small amount, depending on the client's risk appetite, placed in actively managed funds. Financial advisers have different styles and approaches on how they maximise client's returns. It is important to find an adviser that suits your own style.