Why fund fees matter

When of the most important things for long-term investors in funds to consider is costs. Matthew Partridge explains.

It's easy to overcomplicate the process of investing in funds. Active or passive? If active, which manager? Should you opt for income, value or growth, or focus on a particular sector or country? The choice can seem overwhelming. Fortunately, there's one simple thing that matters more than any other over the long run costs. Countless studies have shown that low-cost investment options, ones that keep a lid on fees and charges, consistently beat those that are more expensive. The good news is that cost is also the one thing that you, as an investor, have any direct control over.So how can you find the cheapest funds?

The funds with the lowest fees tend to be passive funds or trackers funds that aim to replicate the performance of an underlying market, rather than trying to beat it. The typical actively managed equity fund in the UK All Companies sector has a total expense ratio (TER) of 1.57%, according to research provider Lipper. Yet the TER for passive funds averages just 0.54%, and fees for some popular trackers are below 0.1%.

That makes passive funds a good choice, given that few active funds beat the market over time. From 2009 to 2014, says passive fund giant Vanguard, 91% of active funds underperformed their benchmark. From 2004 to 2014, say researchers at Morningstar, fewer than 17% of big US growth funds that had been around for at least ten years, had beaten their passive peers. Performance was weak regardless of investing style and the data doesn't even include the funds that folded during that period.

However, if you still want to opt for active investing, at least keep your costs down. Another Morningstar study that examined active-fund performance between 2010 and 2015 found that the cheapest quintile of active US equity funds were three times as likely as the most expensive 20% to beat the index.

Similar patterns held for both bond funds and international equity funds. And just to hammer the point home, a 2009 study by Gil-Bazo and Ruiz-Verdu of the University of Madrid reviewed 3,109 US domestic equity mutual funds active between 1961 and 2005. Their finding? You can probably guess the higher the fees, the worse the performance.

And if we're talking fees, we can't ignore hedge funds. Until recently, these funds typically charged "two and 20" 2% of assets under management, and 20% of any profits made. Yet since 2009, the average hedge fund has returned just 50%, compared to 200% for the S&P 500, according to Hedge Fund Research. Investors have forced down charges, but they still average around 1.7% a year. The lesson to investors is pretty clear most of the time, shelling out for added complexity simply doesn't pay off.

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