Pay attention to the small print with bond funds

If you must invest in a bond fund, then it's vital you do your research, says Tim Bennett - because the yield may not be all that it seems.

Fixed-income funds funds that invest in bonds, mainly have been the hottest investment sector by far this year. According to the Investment Management Association (IMA), fixed income was the best-selling asset class for the 12th month running in August.

By comparison, equity funds saw a net outflow (in other words, more investors cashed in their stocks than bought more) of £604m, the worst figure since November 2011.

As regular readers will know, we've been concerned for a while that a bubble has formed in the sector, and this popularity only makes us more convinced of that. But even if you don't agree with us, there's another reason to be wary of bond funds.

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If you don't do your homework on the way a fixed-income fund levies its charges, then even if the performance stays on target and the market avoids a crash, you still may not get the returns you hoped for, says Ali Hussain in The Sunday Times.

At the core of the problem is a technical distinction, but it's an important one. It all hinges on where the bond fund deducts its annual management fees from. About 30% of funds deduct the money from the capital invested by you in the fund. Another 60% deduct it from the income received by the fund. The rest split the charge between income and capital.

Why does this matter? Because it can make a pretty hefty difference to your potential returns. If the fees come out of your capital, that means less money overall is being invested in the market. That can stack up over the long run, and quite substantially, depending on the growth rate.

Financial advisers AWD Chase de Vere looked at how a £10,000 investment would perform over 20 years. They assumed an annual income of 4%, charges of 1.5% and annual growth of (a rather optimistic) 7%. With charges taken from income, the fund would achieve a total return from both income and capital growth of £14,091. But with charges taken from the capital invested, this drops to £12,013. That's a massive difference of about 17% in terms of the overall return.

Why do funds do this? If customers are more concerned about income than growth, then taking fees from capital instead makes the income yield look better. If you're particularly desperate for income, then maybe you won't think that's a bad trade-off to make.

However, it's important that you understand that this is what you're doing. So if you are determined to invest in a bond fund, despite our suggestion that you don't, then make sure you do your research and find out where the fees are coming from.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.