Two simple steps to avoiding fund management rip-offs

published 21 November 2016

161121-index-b — Active funds are expensive and rarely beat their benchmarks

The UK's financial watchdog has just released another big report into the asset management business.

Guess what?

It turns out that fund managers are charging too much; they aren't very good at their jobs; and they're pretty poor at communicating with their customers.

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It's pretty shocking really, but it's also all stuff that any regular reader will know about.

It's good news that the regulator is onto this, and is promising to make various changes to try to tackle it.

But if you want to make sure you aren't being ripped off by the fund management business right now, what can you do about it?

Fund managers just aren't very good at their jobs

The FCA looked at 722 funds, across 15 asset managers, with a total of more than £560bn of assets under management. And it found all of the same things that we've been complaining about for ages.

It's a litany of objections that you'll probably be familiar with. Charges for active funds aren't clear, or all-inclusive. The ongoing charges figure (OCF) often doesn't include things like trading costs. So the charge that you think you are paying ends up being lower than the charge that you actually pay. The FCA found that "some small funds" had "charges of up to 0.9%" over and above the annual charge. That makes it hard to compare fees across funds.

The FCA suggests introducing an "all-in" fee one annual charge number, and if trading costs or other charges end up being higher than expected, the fund manager has to bear the costs.

The watchdog also reckons £109bn of investors' savings is sitting in "partially active" funds. These are funds that charge "active" fees for "passive" performance.

But the biggest objection is also the one that is the most damning, when you think about it. Most funds just don't do what they aim to do. Investors buy active funds because they expect an expert fund manager to be able to beat the market. Most of them don't.

It's as if nine out of ten plumbers were incapable of changing a washer on your kitchen tap. It's pretty depressing, really.

But the good news is that you really don't have to engage with all of this. This is a minefield you don't have to bother even entering.

The fact is, if you're an even mildly interested investor, you can avoid being suckered by most of the problems with the fund management industry that the regulator is trying to fix.

Here's how to do it, in two simple steps.

Lesson no.1: always consider the passive option first

Over and over again, studies have shown that active funds rarely outperform their benchmarks. So if you cannot be bothered with the hassle and risk of hunting for a decent active manager, who still may not be able to outperform, then it makes sense to go for the passive option instead of hoping that you get lucky.

Studies also show that one factor helps to predict investment performance more than any other cost. Broadly speaking, the cheaper the fund, the better its performance. The FCA reckons the typical active fund charges 0.9% a year, and the average passive charges 0.15%. The watchdog also points out that competition in the market keeps driving passive charges down, whereas there's not much evidence of the same thing happening in the active world.

So no prizes for guessing which type of fund will do better on average.

This is why the hurdle for choosing an "active" rather than a "passive" option for investing in a given market is so high. Passive funds are cheap, and are practically guaranteed to give you the same return as the underlying market, less costs. Active funds, on the other hand, are expensive, and most are likely to underperform their market by an unknown amount.

Put like that, it seems almost madness to imagine that you can buck the odds.

There are reasons to avoid passive options. The index may not actually offer what you want to track. You might be interested in the emerging market consumer story, for example, but the national indices available may only contain large industrial stocks.

However, this is not a problem with the passive structure in itself it just means that you always need to know what you're investing in. And these days, if there's demand for a particular strategy or sector, you can bet someone is working on a passive fund to track it.

Lesson no.2: if you want to go active, look for an investment trust

Investment trusts are listed companies. So they already have independent boards that are meant to hold the managers to account, and the best ones do.

Investment trusts are also sometimes available to buy at a discount. In other words, you can buy the underlying portfolio for less than it's actually worth.

And unlike other active funds, evidence suggests that over the long run, investment trusts in many cases do actually outperform their sectors so you aren't taking the same gamble as with the typical open-ended active fund.

Next Monday (once all the excitement of Budget week is over), I'll look in more detail at exactly how to pick out a decent active fund.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.