The cheapest funds in the UK Equity Income sector outperform their more expensive counterparts over one, three and five years, according to FE Trustnet research.

The funds that are bottom quartile in terms of their total expense ratio (TER), and therefore the cheapest, have beaten those that are top quartile over all three time periods. The longer the time period, the greater the margin of outperformance, illustrating the corrosive impact of charges as time goes on. 

Performance of portfolios over 5-yrs



Source: FE Analytics

Over five years, the cheapest UK Equity Income funds have returned 14.84 per cent, compared with 3.46 per cent from their expensive rivals. They have also been less volatile, losing around 4 per cent less during the down market of 2008. 

Over three years, the margin of outperformance drops to 5.64 percentage points, while over one year, the margin is 1.43 per cent.

Performance of portfolios over 5-yrs

Name	1-yr returns (%)	3-yr returns (%)	5-yr returns (%)
Cheap UK Equity Income funds	18.28	36.37	14.84
Expensive UK Equity Income funds	16.85	30.73	3.46

Source: FE Analytics

The study only included retail funds with a five-year record and excluded trackers. Longer periods were not taken into account, since strong long-term performance often goes hand-in-hand with strong inflows, which often results in a fund group bringing down the TER. 

Oliver Clark-Williams, analyst at FE, says the efficient nature of developed markets such as the UK means that it is becoming increasingly difficult for managers to add value and, as a result, cost is becoming more important. 

"With some exceptions, it appears that funds that operate in developed informationally efficient markets such as UK Equity Income are unable to justify high charges, which appear to have a detrimental effect on performance," he explained. 

 "With information being so easily obtainable it is not clear what benefits an investor would derive by choosing a higher-charging fund." 

"Indeed it would be interesting to know exactly how investors’ money is being spent and how this is justified," he added. 

This is not to say, of course, that it is only cost that separates the cheap and expensive funds. The cheap portfolio of funds includes the five crown-rated Trojan Income and Invesco Perpetual UK Strategic Income funds, which have TERs of 1.06 and 1.19 per cent respectively. 

Both have significantly beaten their sector and FTSE All Share benchmark over one, three and five years, and would have done so even if their costs had been much higher. 

However, given the difficulty of adding value in these markets, Clark-Williams says holding a cheaper portfolio gives investors a much-needed head start.

The trend is also evident in other developed markets, including the US, Europe and Japan.

In IMA North America, a sector that is identified as one of the hardest to generate Alpha in, funds that are bottom quartile for TER have returned 26.1 per cent over five years, compared with 17.42 per cent from those that are top quartile for cost. 

Performance of portfolios over 5-yrs



Source: FE Analytics

While cost is clearly of prime importance in these developed markets, Clark-Williams says the importance of having a low TER diminishes in more specialist sectors, which rely on greater information flow.

"In property and emerging markets, for example, it appears managers are better able to use the fees they charge to derive real performance gains for their funds," he explained.

"With these markets being less efficient, any extra resources spent on improving research capabilities and resources have the opportunity to produce enhanced returns for the fund."

The trend reverses completely in the case of property; according to FE data, the most expensive property funds have lost 11.85 per cent less than their cheaper rivals over a five-year period. 

Those with a higher TER have also returned more over one and three years, although the margin of outperformance is smaller.