Why do we pay fund managers a percentage fee? Why not an hourly rate similar to private doctors, dentists or plumbers? Indeed, you might ask why we pay them at all.
A study by John Bogle, founder of Vanguard Asset Management, reveals that over the past 20 years a simple, low-cost tracker delivered an annual return of 12.8%. Meanwhile, the average equity mutual fund delivered 10% – 2.8% below the market return (about 12.8%). Compounded, that’s a 57% shortfall before tax.
That’s not necessarily because fund managers are bad stock pickers. A study in 2000 by Professor Russ Wermers of the University of Maryland revealed the real problem: fees. High management expenses wipe out even superior performance.
Indeed, £10,000 put in a fund that grows at 7% a year would be worth £14,000 in five years if you paid no charges. But pay 2% a year, and that drops to £12,667. And despite increased competition as the fund management industry has grown, the amount taken as fees is growing. David Stevenson notes in the FT that, by 2005, $320bn was being deducted as performance fees in America, against $50bn 20 years earlier.
Worse, since fees may be taken out up front, you are paying now to get future performance that may never materialise. No one pays a plumber before they’ve fixed a leak, yet we are happy enough to throw cash at fund managers.
So what’s the solution? There are two. First, unless you are after exposure to a specialist sector, you are often better off investing in a tracker fund. True, they can’t outperform the market – they are ‘the market’. But they are cheap, with the expense ratio on a typical fund coming in at about 0.4% compared with 1.5%-1.7% on active funds in Britain.
Next, make sure you’re buying your fund as cheaply as possible. Brokers such as TD Waterhouse, Halifax and Selftrade all offer schemes that let you to buy shares on a monthly basis for between £1 and £1.50 per purchase. You then typically pay a fixed commission to sell, but the overall cost is still kept low.
Sure, not all exchange-traded funds are available through these accounts (TD Waterhouse only lists around 100 of the 500 at the London Stock Exchange). But for simple, quick and cheap exposure to the most popular indices and sectors, it’s an approach that will beat many managed funds, offering similar exposure, hands down.