Why It's Important To Pay Attention To Fund Fees

Posted by John Adam on June 14
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Investors often assume their most important choice when it comes to selecting the funds to buy into is between what those funds invest in. UK companies? U.S. companies or European? Large caps only or medium or even smaller companies also? A global fund that invests only in developed markets or one that invests in emerging markets?

What the funds you choose to invest in themselves invest in is of course an important consideration. But, surprisingly, it might not always be the most important factor when it comes to your portfolio’s long-term returns.

If you are investing for the long-term, many will often want to invest in funds that spread your risk and give you balanced exposure to the world economy and its different sectors and kinds of company.

Why and How Funds Structure The Fees You Pay

If we consider such a balanced portfolio, there’s another factor that will have a big influence on your final portfolio value – fund fees. Almost every fund even passive tracker funds, charge some kind of fee. Fund providers are, after all, businesses and fees are their revenue model.

The complication that rears its head is that funds charge a wide range of fees. They can be (with occasional exceptions above and below) as low as 0.1% per annum and as high as 1.5%. Usually the funds with the lowest fees are popular index trackers like a FTSE 100 or FTSE All-Share tracker.

Fees can be low for passive, tracker funds because the provider doesn’t have to research companies to choose between them. It just invests in a way that the fund’s performance mirrors that of the index.

Funds with the highest fees are usually actively managed funds that invest in companies that involve a lot of research. That’s understandable as paying the salaries of a fund manager and team of analysts typically means greater overheads.

Seemingly Insignificant Differences In Fund Fees Add Up Over The Years

Unfortunately, the old idiom ‘you get what you pay for’ doesn’t typically ring true when it comes to funds. Numerous studies, including one by fund research company Morningstar, have shown that, in fact, the opposite is often the case. The higher a fund’s fees, the greater the risk it will, on average, underperform for its investors.

The reason why is simple. Studies, like Morningstar’s, that have looked at historical fund returns have found no direct relation at all between the level of fees charged by funds and average investor returns over the long term. But over many years, the difference in fees does add up.

The table below, based on one published by U.S. wealth management firm Tweddell Goldberg, shows how big a difference fees make to compounded returns over 10, 20 and 30 years. The figures are bases on a starting investment of £10,000 and returns compounded monthly.

Portfolio Return

Annual Management Fee

10 Years

20 Years

30 Years

8%

0.00%

£22,196

£49,268

£109,357

8%

0.25%

£21,651

£46,880

£101,505

8%

0.50%

£21,120

£44,608

£94,215

8%

0.75%

£20,602

£42,445

£87,447

8%

1.00%

£20,096

£40,378

£81,164

 

Between a fund charging 0.25% and another charging 0.75%, the difference over 30 years, just on a starting investment of £10,000 with nothing else contributed over the period, is over £14,000.

There are many actively managed funds whose investment target is to ‘beat’ an index. There is a reasonable chance they charge a fee of 1%+. You can probably get a tracker fund that mirrors the same index for 0.1% to 0.25%. And the Morningstar study that looked at 9,400 European funds between June ’08 and June ’18 found that fewer than 25% of actively managed funds outperformed their passive counterparts.

To take an example, a 0.5% difference in fund fees on a £10,000 investment adds up to a roughly £14,000 difference over 30 years on the same average gross compounded 8% return before fees.

An investor would understandably expect a fund with higher fees to provide better returns. But the Morningstar data suggests that’s not historically been the case, on average. So all things considered, as an investor, it’s hunting out the lowest fees between comparable funds may give you the best chance you have of getting the best return on a well-diversified portfolio.

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Written by John Adam

John has almost 10 years of experience as a writer and editor on consumer finance and investment topics. An entrepreneur, he has one successful exit behind him and currently writes and consults freelance while enthusiastically pursuing hobbies he's not very good at such as football, squash and raising a small child.

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