Charges can swallow more than you initially invest.
Any old Fool knows that investment fund charges eat into your returns over time. But they don't just take a modest nibble. Given time, they will gobble up a huge portion of your returns.
Incredibly, if you give them long enough, the average fund manager will wolf down more of your money than you invested in the first place, making you thousands of pounds poorer in the process. Don't scoff, as my editor did when I pointed out this strange and alarming fact, just look at the figures.
The hors d'oeuvres
Say you have a lump sum of £10,000, and decide you want to invest it in a unit trust. You spot an advert for WellFed Asset Management's UK Growth fund, and ask if they would take your money. They kindly agree.
The fund has an upfront initial charge of 5.25% (actually relatively modest for a unit trust, many charge 5.5% or 5.75%) which means the fund manager instantly swallows £525 of your money, and they haven't done anything yet.
It gets worse. That is £525 that will never be invested on your behalf. If your fund grows at 7% a year, that £525 would have been worth £1,033 after 10 years (before other charges). After 15 years, it would have been worth £1,449, and after 20 years a hefty £2,032. So the impact of that initial charge is far greater than you think.
And you will never make up that initial loss. It's enough to put you off your food.
And that's only the starter. The main course is the annual management charge, because it keeps munching away at your money year after year.
Annual charges skim off your profits when markets are rising, and twist the knife into your dwindling capital when markets are falling. Let's say WellFed UK Growth has an annual management fee of 1.5% (again, it's not the worst, some charge 1.75%, with performance fees on top).
You buy units worth £9,475, because that £525 initial charge has already been digested.
If the fund grows at 7% a year, your money would be worth £18,639 after 10 years. But after deducting 1.5% in charges every year, it is actually worth just £16,185. Your fund manager has swallowed £2,454.
And the manager keeps on coming back for seconds. The longer you leave your money invested, and the more it grows in value, the fatter the manager gets.
After 15 years, you would have forked out a whopping £4,989 in annual charges, reducing your total fund value from £26,142 to £21,153. Over 20 years, annual charges would have risen to £9,019, slicing your fund from £36,665 to just £27,646.
Since you have also sacrificed £2,032 to the initial charge by now, you are down a total of £11,051 over 20 years. So on your original £10,000 investment, the manager has consumed £1,000 more than you actually put in.
Here's the table that clinched it with my editor. Here are the total charges on £10,000 lump sum investment.
|Investment term||Initial fund|
|Fund total||Total losses|
All figures assume compound growth of 7% a year.
Greed is good, if you're a fund manager. It's not so good if you are picking up the tab.
Of course, there are things you can do to cut the cost, such as buying your fund from a discount broker, who may slash those initial charges to below as low as zero. But most discount brokers still impose full annual management charges, and that is what does most of the damage.
You can put up with high charges if the fund manager delivers market-beating performance. There are some good funds out there, which is why I am still holding unit trusts.
But three-quarters of managers routinely fail to beat their benchmark index, which means most investors are paying sky-high charges for inferior performance. The only person who gets fat on your fund is the manager.
That's why we consider it the height of Foolish table etiquette to shun pricey unit trusts in favour of low-charging investment trusts or index trackers such as exchange traded funds (ETFs), which have typically have no initial charges and much lower annual management fees.
Or better still, peruse the menu of direct equities, and dine à la carte. That way, you get a much bigger helping for yourself. Bon appetit!
More from Harvey Jones:
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