Simple, isn’t it really? You’re not looking to buy something that’s average – you’re looking to buy something that you think will be worth your while. You trust your own judgement, and want to get the biggest possible bang for your buck.
But the answer isn’t quite so simple when put into the context of buying funds.
Cost has become something of an obsession in the fund management industry in recent years. For many investors, an annual charge above 2 per cent is looked upon with suspicion, and in some cases, downright derision.
The compounding effect of annual costs, particularly over the long term, is of course hugely significant, so there’s definite sense in keeping an eye on them.
According to research from Vanguard Asset Management, if one of your investments makes a profit of £10,000 over 20 years, you will pocket just over £8,000 of it if you had paid a 0.7 per cent charge every year. If you had paid 2 per cent, you will only take home £6,500.
Throw into the mixer the potential impact of initial charges (anything up to 5 per cent) and performance fees (which can be 20 per cent) and investors could lose an even greater chunk of their hard-earned cash.
This is only half the story, though. The rise of cheap so-called passive vehicles such as trackers and exchange traded funds (ETFs) is a reaction to the shortcomings of active managers, who more often than not fail to justify their fees.
Take the popular IMA UK All Companies and UK Equity Income sectors, for example. The average fund in both sectors has failed to beat the FTSE All Share – their natural benchmark – over five and 10 years, inclusive of fees. It is the same story across a number of regional sectors.
Performance of sectors vs index over 10yrs
Source: FE Analytics
A fund manager’s number-one priority is to beat the market and therefore maximise returns for investors.
The problem is, very few are able to consistently do this. Some markets are traditionally hard to add value to, but more often than not it’s because the manager is either not very good, or unwilling to take on too much risk for fear of losing their job – or even worse, their bonus....
So, if you can’t trust an active manager to outperform, why not hold a cheap passive vehicle, which gives you returns in line with the market? At least then you know for sure that you won’t underperform.
Why not, indeed. Did you cancel that restaurant reservation yet?
The use of averages in the fund management industry is completely overstated. It’s irrelevant that the average fund underperforms because you’re not buying an average.
You’re looking to pick a fund that stands out above the rest, in the same way that you hope to walk out of that restaurant with a full belly and a smile on your face.
I can already hear the sceptics among you shout: "But past performance isn’t a guide to future performance! How are you supposed to know which funds justify their fees?"
This is the million-dollar question – actually it is closer to a £700bn question according to total fund assets according to the IMA – and one with no clear answer.
Certainly, you can’t trawl through the performance tables and simply pick a fund that has done well over a three-year period.
If you do this, you’re bound to end up disappointed. Even the very worst chef can get lucky now and again.
However, to claim – and I’ve heard it many times before – that the success of a fund manager is entirely down to luck, is not something I can sympathise with. It makes as much sense to me as saying Muhammad Ali’s career was down to a succession of lucky punches.
Let’s look at an example. Aberdeen Emerging Markets is one of the undisputed heavyweights in the IMA Global Emerging Markets sector, so much so that it’s had to close to new money to protect existing investors.
The £4bn fund is in the top 25 per cent of its sector over one, three, five, 10, 15 and 20 years.
It has beaten its MSCI Emerging Markets benchmark in nine of the last 10 calendar years and has not fallen out of the top quartile of its sector over a rolling three-year period since its launch in 1987.
Performance of fund vs sector and index over 10yrs
| Name | 1yr (%) | 3yr (%) | 5yr (%) | 10yr (%) |
|---|---|---|---|---|
| Aberdeen - Emerging Markets | 21.7 | 38.43 | 81.7 | 587.09 |
| IMA Global Emerging Markets | 14.16 | 15.73 | 23.2 | 338.16 |
| MSCI EM (Emerging Markets) | 13.58 | 15.94 | 25.44 | 359.89 |
Source: FE Analytics
Is this a matter of chance? Perhaps. However, given that Aberdeen has one of the most stringent stockpicking processes in the entire industry and has a greater physical presence in emerging markets than any other UK fund house, I’d say it’s quite possible that someone over there knows what they are doing.
With an annual charge of 1.94 per cent, Aberdeen Emerging Markets isn’t cheap, but crucially this cost is taken into account when looking at performance.
The fund has certainly justified its fee so far and given the resources and experience Aberdeen has at its disposal, I think it would take a brave individual to bet against it in the next decade.
You could make a similar case for a whole host of funds – Liontrust Special Situations and First State Asia Pacific Leaders, to name but a few.
One way you can minimise your costs is by picking funds with competitive charges.
If you look hard enough, you can find some proven funds with very low annual costs – though it is important to remember that specialist sectors such as smaller companies and emerging markets tend to be more expensive than others, because of higher research costs.
One cheap option is Francis Brooke’s Trojan Income fund, which charges just 1.05 per cent a year – lower than some tracker funds in its sector.
It has a proven record of outperforming its sector and benchmark with below-average volatility and the manager’s stringent process suggests investors can expect more of the same.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Other bargain funds include Standard Life Global Equity Income, Royal London UK Equity Income and Somerset Emerging Markets Dividend Growth.
Another thing to remember is the shortcomings of tracker funds. Let’s for one minute forget what I said earlier, and use averages again.
Our data shows that the average tracker fund that replicates the FTSE All Share has underperformed the index by a greater margin than the average fund in the UK Equity Income and UK All Companies sectors over one, three, five and 10 years.
Performance of portfolio vs index and sectors
| Name | 1yr (%) | 3yr (%) | 5yr (%) | 10yr (%) |
|---|---|---|---|---|
| FTSE All Share | 24.85 | 45.43 | 30.16 | 157.85 |
| IMA UK All Companies | 23 | 42.27 | 28.71 | 143.63 |
| IMA UK Equity Income | 23.74 | 44.07 | 31.76 | 140.77 |
| Average FTSE All Share tracker | 22.15 | 39.21 | 26.46 | 139.93 |
Source: FE Analytics
Of course, some trackers are better than others and some cheaper than others. However, I’m pretty sure the same argument can be attributed to actively managed funds…
Please understand me; I’m not saying that you always get what you pay for when buying active funds.
As I explained earlier, the majority of actively managed funds have not been worth holding over the last decade, and when you consider that many of those that did outperform have done so with patchy returns along the way, only a fraction will be worth holding in the future.
What I’m saying is that you can find gems out there that have and will justify their costs. Like buying anything, the key is to do your own research. Funds are no different.