If an investor has opted for one of the most expensive funds within the IA UK All Companies sector, there is a high likelihood that it will also be one of the worst-performing funds in its peer group, according to research from FE Trustnet.
In contrast, many of the funds with the lowest ongoing charges (OCFs) have rewarded investors with stellar capital gains and risk-adjusted returns.
However, a number of industry professionals point out that the correlation between charges and performance isn’t necessarily black and white, with some arguing that the ‘cause and effect’ of charges impacting performance should perhaps be turned on its head.
This comes following FE Trustnet’s analysis of two 20-fund composite portfolios within the sector, one containing the funds with the highest OCFs, and the other the lowest. The average OCF of the most expensive portfolio was 1.66 per cent and the average OCF of the cheapest portfolio was 0.55 per cent.
Of course, these portfolios excluded any tracker or smart beta funds, as well as funds that are likely to incur additional trading charges due to their mandate, such as multi-manager portfolios. We also ensured that all funds included in the study had a track record of at least five years.
The data shows that, over this time frame, the lowest OCF composite returned 71.67 per cent, outperforming its IA UK All Companies sector average and the FTSE All Share index by 9.36 and 15.1 percentage points respectively.
On the other hand, the highest OCF composite underperformed its average peer by 8.63 percentage points and the All Share by 2.89 percentage points with an average five-year return of 53.68 per cent. In fact, the highest OCF portfolio underperformed the lowest OCF portfolio during every individual year over this time frame.
Performance of composites vs sector and index over 5yrs
Source: FE Analytics
In addition, the lowest OCF portfolio has achieved seven times the amount of alpha generation than the highest OCF portfolio did over five years at 2.52 and has also been better at protecting investors’ capital on the downside. Over the same timeframe, it has achieved a comfortably lower downside risk ratio (which predicts susceptibility to lose money during falling markets) and maximum drawdown (which measures the most money lost if bought and sold at the worst possible timeframes).
When creating composite portfolios, it is also important to make sure there are no anomalies pushing the average performance in either direction. When looking under the bonnet of both portfolios, though, this doesn’t seem to be the case. In fact, 13 out of the 20 funds in the highest OCF sector have only one FE crown and a further four have been awarded two.
At least seven of the funds in the lowest OCF sector, on the other hand, have been awarded four FE crowns or more. The list includes household names such as Lindsell Train UK Equity, Jupiter UK Special Situations and Franklin UK Rising Dividends.
Nick Samuels, director of manager research at Redington, is unsurprised by the results as he says fees are a headwind to performance and, the higher they are, the higher the hurdle is.
“Sometimes higher fees are justifiable, but it’s typically in a part of the market where liquidity is tight and the manager has a smaller, defined capacity limit or is perhaps doing something unusual, such as adding shorts for example,” he said.
Indeed, two of the funds within the highest OCF list – Ardevora UK Equity and Fidelity FAST UK – are able to take short market positions.
However, Premier’s Simon Evan-Cook doesn’t believe they should be discounted from the study as the funds’ managers only short stocks because they think they can add value over the costs of doing so.
Both he and Samuels say one of the main reasons funds with higher OCFs can underperform is their size. The average size of the funds in the lowest OCF portfolio is £756.8m while the average size in the highest OCF portfolio is £525m. Six of these are £10m in size or less.
“Part of this data is going to be funds that have either never performed well and have always been small so they’re always going to have a high OCF, or funds that were perhaps larger but, because they have performed poorly, have suffered outflows and have had to increase their OCFs,” Evan-Cook explained.
“There is a bit of a ‘cause and effect’ section of this data where you have funds that have performed badly, and that is why their OCFs are high.
“It’s either a death spiral or a ‘nonstarter’; if you’re happy to launch a fund with £3m in it and you expect it to do amazingly well in its first year and raise more money, but you end up doing quite badly, you’re never going to get enough assets to bring the OCFs down. 
“A lot more people take notice of the OCFs now, so if your OCF doesn’t come down, it’s going to be even harder to fill the fund. So sometimes they never get going or they never really reach scale.”
Another factor, according to Samuels and Evan-Cook (pictured), is that some funds in the highest OCF portfolio are what can be described as ‘insurance products’, which they say are more able to demand high charges while performing poorly.
“Some are sold to clients in wrappers and on platforms where the higher fee (and bad performance) can be hidden to a greater degree,” Samuels said. “Managers that have to justify themselves to clients on a regular basis tend to be less complacent in terms of how competitive they are in what they charge, and in terms of the quality of individuals they recruit to run the products.”
Overall though, most industry commentators agree the research supports the idea that high charges can be a big drag on investment performance.
Patrick Connolly, head of communications at Chase de Vere, said: “Investors often have little idea how much they are paying in charges other than a broad acknowledgement that passive funds are much cheaper than active ones.
“This is because they often make decisions based on short-term after charges performance, follow recommendations from discount brokers without doing their own in-depth research and because the investment industry has not been completely open and transparent about how much it charges.”
Neil Shillito, fund manager at Barings, says that there will be an element of index replication within the IA UK All Companies sector to varying extents, even in the more concentrated portfolios. With this in mind, he says charges play an important part in overall performance.
“Most investors are ‘not aware’. This is not a criticism of investors’ intelligence. Why should anyone outside our world be deeply cognisant of what goes on in it?” he pointed out.
“TER, OCF, TCF, TLC. Your average plumber and indeed solicitor, chartered surveyor or osteopath has no idea and even if it was explained, they would be none the wiser.
“Should these people expect more bang for their buck? Not only should they expect it, it should be delivered, but as often as not it isn’t. Why on earth are you invested in this sector? Buy a tracker.”
Ben Willis, head of research at Whitechurch Securities, says the fact that passives have risen in popularity over recent years is indicative of how much more cost-conscious the industry has become.
“Basically, investors need to see that an active manager, after fees, has managed to beat the index/ benchmark over a market cycle and or longer-term,” he reasoned.
“It is only by evidencing a superior long-term track record that the relatively higher fees they charge are justified.
“The big argument for active management is that they are able to participate during market rallies but protect on the downside when markets are selling off. As such, it is always worth seeing how an active fund has held up during periods of market stress.”
Evan-Cook argues that FE Trustnet’s research supports the case for active management, especially seeing as even the highest OCF portfolio performed closely in-line with the FTSE All Share index.
“You would expect both portfolios to be straddling the index with one being 10 per cent behind and the other being 10 per cent ahead, but even the most expensive one is almost in line with the All Share, which is quite a surprise to me,” he said.
“Passives are going to underperform the average fund; that is suggested and presented as a fact and as a mathematical formula that is impossible to break.
“I think investors pay too much attention to charges. If this research shows you one thing, it’s that the approach of finding a great fund manager should be the biggest priority.
“Go for quality, find the best fund manager you can, then worry about the price after that. This is a much better way of doing it rather than just focusing on cost.”