Fund charges: Boring, but vital

Fund charges are a dull subject but, like many such topics, is nonetheless crucial. This is partly because of the impact that compounding has - on annual charges in particular.
 
The issue of charges is linked inextricably with fund returns, risk and volatility. After a decade in which equities have gone nowhere, how many investors rue the day they bought units in an actively managed fund, only to see it underperform, especially after a typical annual charge of 1% or more was taken into account?

Even a 1% charge compounded over 10 years depletes capital by around 10.5%. Add an initial charge of 5%, not unknown in some funds, an in effect you have a 15% handicap to take into account.
 
Some funds merit payments of this sort. Charges are quite hefty, for example, on BlackRock Gold & General, but this fund operates in a highly specialised area and has been an outstanding performer over the last decade. In other words, as always it is worth paying for quality.
 
The same might be said for emerging market funds investing in China, India, Brazil and Russia and Eastern Europe. These provide specialised analysis and investment administration which individual investors are unlikely to be able to replicate.

Their performance over the past year or so speaks for itself. Even here, though, performance of this magnitude reflects recovery from an oversold position and may well not be repeated in 2010.
 
An important part of judging whether or not a fund's charges are reasonable is by looking at its portfolio. If the portfolio of an actively managed fund comes close to hugging a leading index, then it is unlikely to be worth paying high charges when an index tracker fund or exchange traded funds (ETF) could do the same job for a fraction of the cost.
 
Fund charges need to be seen in the context of the likely total return from a fund. This makes the issue particularly important for bond funds in the present context, particularly those that are actively managed and investing in government bonds and higher-rated corporate paper.

In an environment where interest rates may rise in the medium term and where bond prices will therefore be unchanged in capital terms (and perhaps fall in real terms), the full burden of a fund's annual charge has to be set against the yield on the fund.
 
There are many cautiously invested bond funds yielding between 4% and 5% gross. In this context charges need to be looked at as a percentage of the income return, if capital growth cannot be considered likely. The attraction of bond ETFs, with charges as low as 40 basis points, cannot be understated. This shrinks the deduction from gross yield from around a quarter in some cases to less than a tenth.
 
The response to this by bond fund investors has been to go in search of higher returns by veering into funds investing in higher-risk bonds. This is a legitimate response provided that investors bear in mind that seeking higher returns inevitably means that higher risks are being run. Whether such a strategy is legitimate depends on an individual investor's appetite for risk.
 
Hedge funds are a whole different ball game. Although some investors get preferential treatment and performance charges are beset by stringent conditions, hedge fund investors bear hefty charges and face liquidity constraints that can be particularly onerous if times are hard.

Typical hedge fund fees are '2 and 20', a 2% management charge and 20% share of upside performance (subject to particular thresholds and 'high water marks' being attained).
 
Though the best managers can perform spectacularly well, there have been periods when the broad mass of managers have delivered risk adjusted returns (after charges) little better than could be obtained from a simple index fund. Moreover, index funds offer instant liquidity and a greater degree of visibility of performance.

Peter says

I may be doing some investors an injustice by assuming that charges are an under-studied area when it comes to making investment decisions. Indeed my own IFA has suggested I tend to pay too much attention to this subject.
 
It is, however, simple mathematics to work out how fund charges compound and how they can turn a decent return into a mediocre one. I know from my own conversations with fund managers at leading fund groups that bond fund charges are a particularly vexed question.
 
What is worth stressing is, of course, that buying funds through a fund supermarket will almost always result in a reduction in charges and should be the default option for all serious investors.