Brokers, advisers and fund managers are forced by the Financial Services Authority (FSA) to point out that investing can be risky and so returns are not guaranteed. It’s a pity they’re not also made to point out that low-cost products usually outperform high-cost ones. Indeed, many investors don’t realise fees are the most important factor in determining fund performance.
Take US funds. Even after adjusting for the fact that US funds have larger assets under management (and should thus be cheaper), the average total expense ratio (TER) for an American fund is 0.94% compared to 1.67% for a British equivalent. That extra 0.73% doesn’t sound much, but it’s helped US managers to consistently outperform their UK rivals. A recent Lipper study commissioned by the FT shows that American global equity funds have returned 32% more than their British competition during the last 15 years. In the last decade US funds beat UK-based funds across every sector in the study – including Japan, Europe and global bonds. The reason? “Analysts say the most likely reason… is fees,” says Alice Ross in the FT.
This message is reinforced by other research focused on America. For example, Morningstar found that between 2005 and 2010, the cheapest US equity funds returned an average of 3.35% a year, compared to 2.02% for the most expensive. Indeed, Morningstar found that low-cost funds beat more expensive funds in every single intervening time period tested. As a result, according to Morningstar’s John Rekenthaler, savvy US investors now believe that “active managers are overpaid salesmen and you’re better off not listening to their nonsense and buying an index tracker”.
Leaving aside that debate over the specific product chosen; why are American investors getting a better deal overall? A key reason is differing fee structures for financial advice. In Britain independent financial advisers (IFAs) receive a direct commission on sales, so funds typically include an extra 0.5% fee in their overall charge to cover it. This keeps TERs higher than in America, where advisers charge clients directly – meaning any commission is not tacked onto fund costs.
Fortunately, there is hope for British investors. The FSA is re-organising the financial advice industry – the 2013 Retail Distribution Review will ban IFA commission and stop funds charging the extra 0.5%. Until then, it is well worth shopping around for a low TER and using a fund supermarket to avoid initial fees.