Call the tune if you are paying the piper

Right now, investors might be wondering exactly why they are paying large annual fees to fund managers who have managed to lose a considerable amount of money in recent months.

While there is a price to pay for asking skilled investment managers to look after your money, there is naturally going to be some grumbling when so many funds have failed to outperform even the FTSE All-Share index, in which exposure can be bought relatively cheaply through an exchange traded fund or a simple tracker product.

Fee levels are even more open to question when retail investors in other regions generally pay much less, and indeed when institutional investors in the UK can be charged less than retail investors in the same fund.

And when funds close their doors on redemptions – as many are doing in the commercial property sector – then the fees look increasingly irksome.

Data provider Lipper says that total expense ratios, (TER) which are the “drag” on fund performance caused by all annual operating costs including the annual management charge, have gone up steadily in the last few years – from 1.52 per cent in 2003 to 1.61 per cent last year on an asset-weighted basis.

Fees vary between sectors, with Asia the most expensive and money market funds the cheapest. But, crucially according to advisers, fees never vary on performance so these charges will be levied on the very best and the very worst funds.

Interestingly, says Justin Urquhart-Stewart, of Seven Investment Management, Lipper data show that European investors pay twice as much in fees for mutual funds as those in the US.

“I’ve never really heard a good answer to why this is,” says Urquhart-Stewart.

One fund manager, who asked not to be named, said that it was legitimate to question your manager if there was a consistent underperformance.

He pointed to some of the so-called absolute return funds, which are designed to cope with falling markets, often with promises of a return above the bank rate, as being particularly poor value right now, given the often high fees they command.

A 2006 European study by Standard & Poor’s found that none of the 21 absolute return funds it tracked met return targets after fees, and only four matched cash returns over a year.

According to Funds Library, a third of UK funds in its absolute return/protected returns sector lost money over the past 12 months, while a further third failed to beat cash returns in that period.

But many advisers, particularly those who favour more “passive” and normally cheaper forms of investment such as trackers, say there are guilty parties in the overall fund sector where performance simply does not warrant the cost.

James Norton, of Evolve Financial Planning, says that if you had invested £10,000 in 1962 into the FTSE-All Share, you could expect around £308,000, a compound annual return of 8.3 per cent, excluding costs.

Assuming an index fund has a cost of 0.5 per cent a year, he says, total returns fall to just under £253,000. With total expenses of 1.5 per cent a year, that return would fall to £169,000, 45 per cent lower than the return of the index.

He adds: “Fund managers like talking about compound returns. But you never hear them mention the powerful effects of compounding costs. Active management does not pay.”

So to attract investors put off by high fees, Aegon is this week offering the fund equivalent of a new year sale. From this week, it will offer a discounted initial charge on three funds in the UK range until 30 April.

Initial charges on the UK Opportunities fund and the UK Equity fund will be reduced from 5.5 per cent to 3 per cent.

The High Yield fund, managed by Phil Milburn, will have its initial charge discounted from 4.5 per cent to 3 per cent.

Standard Life Investments is offering a similar incentive on its investment trusts, removing the initial charge on investments in its range entirely until May.

But these look more like marketing exercises to attract money into individual savings accounts before the tax-year end. So many advisers believe there should be a more widespread review of the fee structure in UK fund management.

“The cost of active management really has to come down,” says Urquhart-Stewart. “There are a few really good funds, which earn their fees, but an awful lot of average funds and some very bad ones that don’t.”

Both Urquhart-Stewart and Norton are fans of tracker funds and exchange traded funds, which are low cost vehicles that normally mimic the performance of an index or a basket of assets.

These, says Urquhart-Stewart, can be as safe or as risky as the investor would like, which means that an “active” portfolio can be created – for example, made up of exposure to the FTSE-100 index alongside exposure to gold or raw materials, or a “short” position against US equities.

Investment trusts are also often cheaper, with larger ones having an average TER of around 0.8 per cent, half that of the equivalent unit trust.

Even so, most advisers still suggest that good active managers will always be the cornerstone of an investor’s portfolio, if only to take the effort out of investing in stocks.

With the largest ever flow of money out of UK funds in 2007 last month, according to figures from the Investment Management Association, there are likely to be a few fund managers wondering how to arrest the decline.

A hard look at fee structures in the UK would not be a bad place to start.

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