FOOL'S EYE VIEW
How Low Charges Improve Your Investment Returns

By Maynard Paton (TMFMayn)
February 20, 2002

Carburton Street, London -- There are few certainties in the world of investment. However, you can be sure whichever way you invest in the stock market, charges will come into play. And over time, the cumulative affect of charges can have a notable bearing on your overall investment performance.

For example, take four imaginary unit trusts. Trust A has an initial charge of 5% and an annual charge of 1%. Trust B has no initial charge, but levies an annual charge of 1.5%. Trust C has an initial charge of 5% and an annual management cost of 1.5%. And trust D has no initial charge and an annual cost of 0.5%. All the unit trusts invest in the same underlying investment, which provides annual growth of 10%.

Trust A, therefore, has a growth rate of 9% (10% minus 1%). B and C have growth rates of 8.5% (10% minus 1.5%). D has a growth rate of 9.5% (10% minus 0.5%). Now assume £100 is placed within each trust. After various time periods, the investments (to the nearest pound) would look like this:

    Time    Trust A      Trust B       Trust C       Trust D
   Period (9% growth) (8.5% growth) (8.5% growth) (9.5% growth)

   Start       95          100           95            100
  1 Year      104          109          103            110
  2 Years     113          118          112            120
  5 Years     146          150          143            157
  10 Years    225          226          215            248
  15 Years    346          340          323            390
  20 Years    532          511          486            641
  25 Years    862          769          730            967

Compare trusts B and D, both of which don't pay initial charges. After 25 years, the investor holding trust D would be 26% better off than his counterpart in trust B. That notable outperformance was simply due to a 1% lower annual management charge. Then compare trusts A and B. Although hampered at the start by the 5% initial charge, the value of trust A exceeds the value of trust B (that has no initial charge) after twelve years -- again, because of its lower annual management charge.

The key points to note here are:

* All things being equal, lower annual management charges will generate greater net investment returns, and;

* Over the long-term, annual management charges will have a greater affect on your investment performance than initial charges.

All things being equal?

But when choosing a unit trust, are "all things equal"? Not really. It's unlikely any four randomly chosen unit trusts will provide identical pre-cost returns over the long-term. And by and large, it's the underlying performance of the fund -- not the charges -- that will have the greatest affect on your investment performance.

The debate about whether you can pick an investment fund that will do better than average over the long-term continues to rage. But if you feel one "UK Equity Growth fund" looks very much like another, then charges should be an important factor. Note that, because they're not reliant on highly paid fund managers, index trackers tend to have the lowest charges amongst investment funds.

Indeed, returning to the above table, comparing trust C to trust D is a bit like comparing a managed fund to an index tracker. Many managed funds impose initial charges of 5% and annual fees of around 1.5% (like trust C). Meanwhile, there are many trackers that have no initial charge and an annual cost of below 1% (like trust D).

After 25 years, the difference between the eventual returns from trusts C and D is some 32% in favour of trust D. From that figure, a typical managed fund would have to beat an index tracker by some 1.1% a year for 25 years just to cover the additional charges. And if that 1.1% figure doesn't sound very much, it's worth remembering many pundits are expecting the stock market to grow well below its 12% historical return in the future.

While every investment fund has to outline its charges within a key features document, there are websites available to help filter out some of the more expensive ones. Late last year, the Financial Services Authority launched its comparative tables. These tables highlight the total charges payable on various investment funds over different timescales. The Financial Times has recently began its own Fund Ratings tables, too.

But as mentioned earlier, the underlying investments within your chosen fund will have the greatest affect on your net return. But if you're not confident of assessing the long-term future performance of a particular fund, then looking for the lower charging ones goes some way to help to improve your long-term investment returns.

More: Visit The Motley Fool's Index Tracker Centre | How To Choose An Investment Fund