Fees: why pay more for bad performance

It's rare to find that prices for the best products fall, while the costs of the worst go up but in the topsy-turvy world of funds, this seems to be the case. Investment fund research group Lipper Fitzrovia has found that index funds (which simply track the performance of a given market or sector) are becoming cheaper, with the total expense ratio (TER) on the average fund falling to 0.94% a year in 2006 from 1.12% in 2001. The drop has been driven by rising competition as smart investors flock to the cheapest index funds providers who have cut costs "have obtained higher fund inflows as a result", writes Jonathan Davis in The Independent.

On the other hand, the cost of actively managed funds is on the rise. There has been a steady increase in management fees over the past five years, from 1.21% to 1.39%. And there's no drive to cut costs. "In fact," as Davis says, "the main focus of many fund providers is to find ways to raise their charges", with innovations' such as performance fees and more complicated products. Investors should also be aware that more than half (52%) of the annual fee on a typical managed fund is due to commission payments made to independent financial advisers (IFAs). As we've pointed out in MoneyWeek before, if IFAs really were independent, commission charges would be falling because they would have no impact on an IFAs' recommendation. That they are rising shows they work and that some choose funds on the basis of how much money they stand to make, not their suitability for clients.

Another reason to avoid actively managed funds comes from a study by City University's Cass business school, which showed that the funds most popular with private investors in the US tend to outperform their peers. Good news? Not really, says John Authers in the FT. Even though they beat their peers, they still underperformed the broader market on average. "To be smart' when choosing between mutual funds means to limit the amount by which you fail to match the market. It does not mean that you beat it."

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So why pay more for underperformance? The typical exchange traded fund can be bought or sold like a share and charges less than 0.5% a year. With more than 350 to choose from, you can track the market of your choice and you don't have to pay commission for the privilege. See www.ishares.net.