High fees are no guarantee of better returns

While investment fund charges are certain, the enhanced performance some promise is not, writes Laura Slattery

Some investments may actually transpire to be the splutter-free generators of endless wealth that the brochure suggested they would be. But along the way there will be fund managers, investment houses, administrators, banks, sales agents and financial advisers who have to be paid.

Entry charges, early encashment penalties, annual management charges and internal charges such as stamp duty and legal fees all combine to reduce the amount of money the investor receives when the time comes to cash in.

Investors often pay above-average charges because they believe the more expensive investment will bring them above-average returns.

But others do not realise exactly how much they are handing over in fees, commissions and charges and how much an extra 0.5 per cent or 1 per cent charge can cost them in the long term.

While charges are certain, the enhanced performance is not, so more expensive funds are by definition a riskier buy.

Michael Kiernan of MyAdviser.ie cites the example of Irish Life, which offers its own funds at an annual management charge of 1.5 per cent, and funds managed by Fidelity Asset Management, with an annual management charge of 2.25 per cent.

Contrasting the performance of comparable Irish Life and Fidelity European equity funds shows that over one and three years, the Fidelity fund has proved worth the extra 0.75 per cent charge.

But over the long term, this charge can add up, Kiernan points out.

If €50,000 was invested in each fund and both achieved growth of 6 per cent per annum, after 10 years the Irish Life fund would wind up about €5,900, or 8 per cent, higher than the Fidelity fund. Investors need to ask themselves if they are willing to risk 8 per cent or more of their fund in pursuit of the higher performance that Fidelity has achieved in the past, Kiernan explains.

And a risk it is: the mantra that past performance is no guarantee of future returns is repeated by financial advisers with good cause.

Annual management charges vary from about 0.5 per cent to 2.5 per cent, with the average charge clocking in at 1.5 per cent.

The amount investors pay should depend on the type of investment fund they are ploughing their money into.

A passively managed fund such as one that tracks a stock market index (for example, the Iseq or FTSE 100) should have lower charges than a fund that is actively managed and has a fund manager making regular strategic decisions about where and when to invest.

But is fund managers' expertise worth the extra expense?

Over the long term, it is usually not, says Simon Shirley, director of accountancy and wealth management firm BDO Simpson Xavier.

"There are very few fund managers who consistently get into the top quartile in terms of performance year-on-year. Only a minority will consistently outperform over a 10- or 15-year period," he says.

There are exceptions, and Shirley cites the Friends First Irish Commercial Property Fund, which has been the best performing fund of its type over three, five and 10 years.

But passively managed funds are appropriate for most investors, Shirley believes.

He cites Quinn Life as an example of a fund provider with low charges on its index-tracking funds, with annual administration fees of 1 per cent on many funds and no entry charges or early encashment penalties.

But not all life companies reduce the management fees on passive funds and, in any case, an even cheaper way to invest in a fund that tracks an index is an exchange traded fund (ETF).

Launched last year, the Iseq 20 ETF, in which investors' money is used to buy shares in the 20 biggest listed companies on the Irish Stock Exchange, has a "total expense ratio" of half a percentage point, says Nigel Poynton of NCB Wealth Management.

ETFs can be used to invest in almost any part of the market: Japan, China and the oil sector are three popular choices for investors, according to Poynton.

The downside is that there is no chance of outperforming the market, he notes.

The annual management fee is only one part of the story. Most funds will either have entry charges or early encashment charges.

In recent years, most investment fund providers have moved away from entry charges such as "bid offer spreads" in favour of charging encashment penalties on a sliding scale over the first five or six years, starting at about 5 per cent.

One exception is Rabodirect, which has entry and exit charges of 0.75 per cent on top of annual management charges but, like Quinn Direct, no steep early encashment fees.

"You shouldn't be rushing into these funds if you have less than a five-year term in mind. But if you do have to encash early because you need the money for some reason, you won't be penalised," explains Shirley.

His opinion is that ultimately the Rabodirect charges work against most investors.

"The advantage of early encashment penalties over the upfront fees is that you get a higher allocation in the investment from day one and defer fees to a later date," says Maeve Corr, director of Deloitte Pensions and Investments.

"Your investment returns are on a higher initial amount invested. However, potentially, you will end up paying higher fees if you come out of this at the early encashment point," says Corr.

The risk of having to pay these penalties is not to everyone's liking. Many clients prefer to know the exact upfront cost and opt for the upfront charges, she adds.

But investors need to look at the total expense ratio, Corr says. This includes custodian fees, stamp duty, stock transfer costs, policy fees, audit and legal fees. "These are typically charges against the fund directly and are not always included in the annual management fee."

Commissions paid to the adviser or sales agent also determine the level of charges investors pay, she says.

This can reduce the initial allocation rate - meaning less than 100 per cent of the money is invested on day one - and in cases where "trail commission" is taken, the annual charges can increase.

Under the rules of the Irish Financial Services Regulatory Authority, there is an obligation on the sales intermediary to disclose this commission.

"In practice, however, investors find that these may not be apparent and are often buried in the small print," says Corr. "We recommend that investors look for fee-based investment advice where remuneration is agreed upfront."

Some investors are happy to pay commissions rather than fees, but they should know exactly how much of their returns they are handing over.

Kiernan of MyAdviser.ie gives the example of someone who invests €50,000 as a once-off lump sum.

"You could be typically offered 100 per cent allocation, no bid offer spread and a 1.5 per cent management charge. This plan would have an exit charge on it of 5 per cent reducing to 0 per cent after five years."

The intermediary in this case would be paid 3 per cent of the initial investment and an ongoing commission of 0.5 per cent of the fund value this year, or €1,500 in the first year and an additional €250-plus each year for the life of the fund.

"If you feel that this is good value for the service received, then there is no problem. If you feel you have not received good value, then shop around."

Depending on the size of the investment, an independent financial adviser may choose to reinvest some of the commission he or she is paid on behalf of the investor, says Shirley, meaning a good broker will give the investor both independent advice - on the entire market if they are authorised advisers - and better terms.