Do expensive funds perform better than cheaper ones?

When it comes to price, Brits often associate higher cost with better quality. It’s easy to see how investors could assume that expensive funds should generate a better return than cheaper ones, but this is a myth that could be doing more harm than good.

Fees are a fact of life for investors. Unfortunately, the more you pay, the less of your money you get to keep and it’s crucial investors understand how cost can impact return.

You can never guarantee a return from your investments, but you can control how much you pay in charges. It’s crucial you understand how much you have to pay, otherwise this could seriously hold you back from achieving your financial goals.   

What are you paying for?

Funds charge an annual management fee, which covers the running of the fund and is where the asset manager usually makes its profit. This can vary wildly from fund to fund, and can reach as much as 2%. On top of this cost you’ll likely have a platform fee, or management fee from a wealth manager, this is what enables you to access a particular fund.

There are two main types of investment strategies; active and passive. Whilst passive investments try to replicate the returns on the market, active managers try to outperform it.

Trying to beat a benchmark takes up more resources than if you were trying to replicate it. Time is money, as the adage goes, and investors have to fork out for the prospect of beating the market – whether it actually happens or not.

Compensating fund managers for their time and expertise, these expensive management fees are usually disclosed as a percentage of the total amount of the money the investor has in that fund.

What’s the ongoing fund charge?

The ongoing fund charge is a more accurate reflection of how much a fund might cost you over 12 months, but still doesn’t reveal the whole picture.

By investing in a fund, you might be charged the cost of your asset manager buying and selling investments, certain admin charges, or platform costs from your provider. These costs add up quickly and it can be difficult to understand exactly how much you’re really paying.

Do expensive funds perform better?

So, asset managers charge big bucks on the promise that they could deliver outperformance; but do the more expensive funds actually perform any better?

Two-thirds of large-cap active fund managers failed to beat the S&P 500 index in 2016, research from S&P Dow Jones Indices shows. The smaller asset managers didn’t fare any better, with 90% of mid-cap and 86% of small-cap fund managers missing the mark.

It’s a tough task asking active funds to outperform passive funds after fees for a simple reason; they have to get a higher return to compensate for their higher fees.

Granted, you can’t expect a fund manager to outperform every year, especially when markets are performing well, but a look at longer time horizons showed the majority of active fund managers also failed to outperform over one, three, five, 10 and 15 years.

The UK regulator, the Financial Conduct Authority, found a negative relationship between the cost of a mutual fund and the performance of the fund manager in its final report on the asset management industry.

The research even found that more expensive funds underperformed cheaper active funds, although this varied across sector.

The prospect of outperforming the market is not a concept many will be staunchly against, but the high fees that go hand-in-hand with active management do eat into investor returns and delay the achievement of financial goals.

Although everyone has the right to protect their money and grow their wealth for the future, many are put off by the high barriers to entry. Instead, investment products should be low-cost, transparent and effective to encourage savers to start preparing for their future, whatever it holds.