How Fund Managers Eat Your Wealth

Published in Investing on 28 September 2010

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.

Dig in!

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.

More, please!

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.

Burp!

Here's the table that clinched it with my editor. Here are the total charges on £10,000 lump sum investment.

Investment termInitial fund
charge
at 5.25%
Annual
management fee
at 1.5%
Fund totalTotal losses
from charges
10 years£1,033£2,454£16,185£3,487
15 years£1,449£4,989£21,153£6,438
20 years£2,032£9,019£27,646£11,051

All figures assume compound growth of 7% a year.

Bill, please

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.

Eat that!

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:

> With The Motley Fool's Share Dealing Service, you can buy and sell shares in real time for a flat rate of just £10. You can also shelter them in an ISA or SIPP. Open an account for free today.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

MunroMan 28 Sep 2010 , 4:48pm

To be fair you should point out that there is a cost to buying equities directly, stamp duty and commission, which you don't get if you buy a fund directly that has no initial commission.

Morever, buying individual shares is much riskier than buying a collective. And that risk is hard for individuals to quantify.

rober00 28 Sep 2010 , 5:09pm

Additionally I have noticed whereas during and after the credit crises, many businesses cut their costs to encourage the customers to buy, many Unit Trusts/Oeics actually increase the level of their charges.
How that for greed!!!

As a regular IT investor I have noticed that the boards of some trust at the same time negotiated significantly lower charges from their management companies!!!

In the end you pay your money and takes your choice. I know where that is for me, I do NOT own any Unit Trusts/Oeics.

jaizan 28 Sep 2010 , 10:00pm

On the whole, unit trust charges are way too high.

Firstly, you should only buy when the 5% initial charge is mostly discounted.
Secondly, only buy when the fund has a long term record of outperformance which justifies this AND still has the same manager in place.
That's very few funds indeed.
I have invested in just ONE unit trust. The rest is in shares, ETFs & Investment Trusts (where the discount tio NAV can offset the often more reasonable charges).
Even then, the Investment Trusts have to offer a track record of outperformance, or exposure to a market I cannot easily directly invest in.

NeilW 29 Sep 2010 , 11:08am

There's also the time element.

If you have a gardener to look after your garden, you would expect to have to pay him to keep things neat. But you would save time that could be used elsewhere. Or you could cut the grass yourself, save a few quid and lose a couple of hours.

If you own a property and rent it out via an agent then the agent will expect a cut. Alternatively you could do the property management yourself. You'll get more money but it costs time.

If you own shares directly, then you'll have to put some time into monitoring and watching them.

It's the same with all collective investment funds. You swap money for time.

GoodBloke 29 Sep 2010 , 2:24pm

My SIPP and ISAs are with Hargreaves Lansdown and if I buy a fund, then depending on the fund most, if not all of the initial charges are not charged (discounted).

Many funds provide access to markets that I would otherwise have difficulty accessing and as NeilW above says, don't have the time to research. For example, how would I invest in Russia?

I used to believe in low cost index trackers, but have found that the returns have usually been less than actively managed funds even allowing for the charges. Sure some funds haven't performed very well (e.g. Neil Woodford's Invesco Perpetual Income returning since purchase 5% p.a.), but some (e.g. Jupiter India returning since purchase 33.2% p.a.) have performed very well, far outweighing a cheap index tracker (e.g. L&G returning 1.4 p.a. since purchase).

oldpoliker 29 Sep 2010 , 7:42pm

I would loke to know is what happens to the dividends when you buy a tracker product. Sure they will follow the ftse 100 but the dividend income just seems tobe syphoned off never to be seen again. This on top of the management fee.

EdSwippet 29 Sep 2010 , 10:04pm

I would loke to know is what happens to the dividends when you buy a tracker product. Sure they will follow the ftse 100 but the dividend income just seems tobe syphoned off never to be seen again. This on top of the management fee.

Not at all. All reputable index tracker funds return to you both the dividend and the growth. If you choose a fund's accumulation units, the dividends aren't paid out directly, but are instead reinvested for you in the fund automatically. If you choose income units, dividends appear as discrete payments. Either way, though, you get them.

abrahamisaacs 30 Sep 2010 , 2:28am

NeilW's analogy to the costs of garden maintenance and rental properties is misinformed. Let me put you straight. A gardener only charges for the hours worked whereas a fund manager charges an upfront fee for doing nothing plus the ongoing management charge is actually a tax on the value of your investment (even when the value goes down). Similarly a real estate agent only charges a commission on the rent you actually receive plus their admin costs such as lease preparation or chasing up arrears - they do not charge an ongoing tax on the value of your property. So I agree wholeheartedly with Harvey Jones that the entire basis of fund management charges is badly flawed. These guys who should be vilified moreso than the bankers.

Scamspy 30 Sep 2010 , 2:31am

Brilliant work. Some replies appear to conclude (i) that the (high cost) fund you pick has reputable management! [like Lehman Brothers or Bank of Scotland or Goldman Sacks] (ii) if you pay a large fee you will get competent management [5% + 2%], (iii) competent management will always yield returns in excess of (7%) [really?]and (iv) percentage fees are a fair way to charge for ANY amount invested [come on].
I will stick with selecting a number of low cost funds and then researching their history and managements to choose the best.

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