We've always been big fans of passive' investing at MoneyWeek.
Passive funds simply track the performance of an underlying index (the FTSE 250, for example). They don't try to beat the market, unlike active' funds.
They're not perfect by any means, but they do have one big plus point they are usually cheap.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
However, new rules banning commission payments are putting pressure on fund managers to cut prices on active funds, which may eventually make them more competitive. We're also big fans of investment trusts, which have regularly shown an ability to beat the market.
So sometimes it can be worth paying more for the services of a good active fund manager. The tricky part is working out just how much they cost many charges remain hidden from view.
But the good news is that there's now a very useful tool online that can help you to check if a fund is genuinely cheap or not
The big problem with active funds
If a fund is going to cost you 2% a year, that means the manager has to beat the market by 2% a year just to match a tracker fund's performance. That may not sound a lot, but to achieve that level of out-performance consistently is difficult.
Worse still, the official figures often understate the true cost of a fund.
However, a new tool has made it much easier to figure out the real cost of investing in a particular fund: the True and Fair calculator.
I really like this tool because I can now pick out low-charging funds with more confidence. If I see a fund that appears to be cheap, I can use the calculator to check that it's genuinely a low-cost investment.
Here's how it works.
If you've ever tried to compare the cost of different funds before, you may have been confused by some of the jargon.
Some fund management companies like to talk about the AMC (annual management charge) while others talk more about the TER (total expense ratio).
Of the two, I prefer the TER because it includes some admin costs that don't show up in the AMC. But even the TER doesn't cover all the costs. Most importantly, the TER doesn't include all the dealing charges a fund has to pay when it buys and sells shares.
Anyone who has ever traded individual shares knows that dealing costs can be a major drag on your returns if you're not careful. So why would you ignore these charges if you're looking at a fund?
So for any fund, the True and Fair calculator estimates what the hidden costs will be and gives you a true cost figure. And it doesn't just give you a percentage figure, it tells you the actual cash cost.
What this means in practice is that if you're looking at a fund with, say, a 1% TER, the actual cost may well be closer to 1.5%.
How the calculator works
JP Morgan Chinese
Temple Bar Investment Trust
I've assumed we're investing one year's individual savings account allowance (£11,520), and that we're going to hold onto the investment for five years in total.
I've also assumed that JP Morgan Chinese will return more than Temple Bar. That's because the JP Morgan fund is arguably higher risk than Temple Bar, which focuses on UK stocks.
So we've assumed that JP Morgan will return 7% a year, while Temple Bar returns 5% a year but clearly those figures could end up being very different in reality.
|Number of years investment held for||5||5|
|Estimated annual return before costs||7%||5%|
|Annual fund charges||1.41%||0.51%|
|Estimated annual costs of fund manager's buying and selling||0.34%||0.09%|
|Annual total cost of investing||1.87%||0.63%|
|Estimated total costs (over five years)||£1,365.15||£432.75|
|Projected total gains over next five years after charges||£3,272.00||£2,750|
So what does the True and Fair calculator tell me? On the JP Morgan side, the trust's marketing factsheet' says that the AMC is 1%, while ongoing charges' are 1.41% a year. But the True and Fair calculator suggests that a more accurate figure for charges is 1.87% a year, once you account for trading.
The Temple Bar investment trust focuses on the UK stock market and charges 0.51% a year. The more accurate true and fair' figure is 0.63%, much cheaper than the JP Morgan trust.
So while the JP Morgan fund delivers a bigger return than Temple Bar over the five years, it's only because I've assumed that the JP Morgan fund will grow more quickly. If the two funds grew at the same rate, Temple Bar would win out because the charges - hidden and otherwise - are much lower.
In fairness, the True and Fair calculator isn't perfect as there is some guesswork involved with the total cost estimates. But it's still pretty useful in my book.
The best thing about the calculator is that you can play with the numbers and look at various different scenarios. It helps you to figure out whether it might be worth paying the extra charges in the hope of securing a bigger return.
In this case, for example, China is one of those markets where it might be worth paying for active management, simply because the tracker funds that exist are very heavily weighted towards certain companies and sectors.
If you believe the market can deliver better returns than the UK in the coming years, then it might be worth swallowing the extra costs. As I've already said in a recent Money Morning, I think now could be a good time to invest in China, given the gloomy sentiment towards the market. But you can see that the extra return will have to be fairly significant to justify that extra expense.
I'd urge you to go and have a look at the calculator. If you already own funds in your portfolio, run them through it and if you're shocked by how expensive they are, then make sure their performance has justified the cost. If not, dump them and look for something cheaper.
Our recommended articles for today
Buy the bookie cashing in on Asia's sports mania
Don't get suckered by student accommodation
Ed has been a private investor since the mid-90s and has worked as a financial journalist since 2000. He's been employed by several investment websites including Citywire, breakingviews and The Motley Fool, where he was UK editor.
Ed mainly invests in technology shares, pharmaceuticals and smaller companies. He's also a big fan of investment trusts.
Away from work, Ed is a keen theatre goer and loves all things Canadian.
Rents are still rising but could reach their limit by 2025 – is buy-to-let still worth it?
News Research by Savills claims rental growth could hit 9.5% this year, but will start to slow. Is buy-to-let still worth investing in?
By Marc Shoffman Published
The fallout from the war on landlords
Investors fleeing the market and the rise in rents are affecting us all.
By Charlie Ellingworth Published