Don’t ignore fund fees: go for cheaper options

What's the most important thing to consider when buying a fund? The track record, say some. For others, it's more important to look at the sectors the fund is invested in. There's some truth to both claims, but the key thing to check before you even consider investing is how much the fund costs. This is because it's very hard to predict a fund's future performance. In fact, ardent believers in the efficient-market hypothesis (the theory that markets are perfectly priced at all times, given the available information) argue that it's impossible to beat the market over long periods, except through luck.

Plenty of people disagree and the existence of bubbles, such as dotcom mania, suggests that investors aren't as rational as we'd like to think. But the fact remains that, in an uncertain world, fees are the one factor affecting future returns that an investor can be absolutely certain about before investing.

And that's more important than ever because, according to research by financial consultants Defaqto, commissioned by The Independent, fees are still rising. The average fund now charges 1.37% a year, compared to 1.23% at the end of the 1990s. One in 14 charge 1.75% or more, compared to one in 50 back in 1999. Some are even acting like hedge funds by adding performance fees.

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For example, New Star's Heart of Africa fund charges an annual management fee of 1.75% and then 20% on top of any return it makes on 3% above Libor. With Libor now standing at just under 6%, New Star takes £1 for every £5 it makes above a 9% return. That's quite a chunk; even the smallest difference in fees translates to large sums over the long term. Let's say you have £10,000 invested in a fund that gives a 10% annual return over 20 years. With charges of 1.5%, you'd have £49,700 in the bank at the end of the 20 years. But if the fund has expenses of 0.5%, you'd end up with about £60,800.

So going for the cheapest option makes a big difference. Add that to the fact that few managers beat the market over the long term, and all the evidence points to exchange-traded funds (ETFs) and tracker funds being by far the best bet for investors. ETFs don't employ expensive teams of analysts to manage your money. They just track the performance of a particular market index, basket of stocks or commodities.

If you are looking for a bog-standard FTSE 100 tracker, you can track the UK blue-chip index for an annual Total Expense Ratio (TER) of just 0.3% with the Lyxor FTSE 100 ETF (L100), or for 0.28% with Fidelity's MoneyBuilder UK Index tracker fund.

But why restrict yourself to Britain? Of all the global markets, we think Japan looks best placed to thrive in the coming downturn, as mentioned in last week's cover story. The iShares MSCI Japan Index (EWJ) fund tracks the Japanese market and has a TER of 0.52%. For a full list of ETFs, see Trustnet.