If it is so difficult to identify a well-managed investment fund, is it best to pay the experts to find a selection of funds for us?
I wrote recently on how, in the world of managed investment funds, it is really hard to identify one that’s going to perform well. The problem is that the quoted figures for past performance are, as the disclaimers say, really no guarantee of the future. In fact, they're usually not even a vaguely useful guide, never mind anything close to a guarantee.
It’s true that there is potential for a good fund to beat the market, but it probably takes as much knowledge and hard work to find such a fund as it takes to identify good individual shares in the first place. So, just as funds take out the hard work of individual stock-picking, why not go for a “fund of funds” to take the hard work out of fund-picking?
Fund of funds
What is a fund of funds? It’s really just what its name suggests. If we can't decide which fund or funds to buy ourselves, we instead send our money to the fund managers who run the thing, and those supposed experts, instead of trying to find shares that they think will out-perform the market, instead invest in a selection of what they hope will be the best performing funds. And they know more about how to find good funds than we do, right? We'll come back to that, but first let’s think about what it’s going to cost.
Two lots of charges
The really big downer for a fund of funds is that they charge twice for the privilege of having them invest our money. Why? Well, the funds that the fund of funds invests in will all levy their own management charges to start with, and then the fund of funds managers will take their slice off the top, too. General share funds typically charge around 1.5% per year, but because they are investing aggregated large amounts, the fund of funds can usually get that down a bit. But once they add their own cut the total annual charges typically add up to about 2.5%. If we compare that 2.5% with the 1.5% of a plain shares funds and the typical 0.75% for a tracker, we need quite a performance improvement for a fund of funds to earn its keep.
Let's compare
To see what effect the different charges make, we need to run some numbers. Let's assume a 5% return per year from the underlying shares over the next 30 years (I personally think that shares will do a lot better than that over the next 5 years, but for the longer term let's stick with caution). If you invest £100 a month for 30 years, here's how our three typical funds will pan out:
| Fund | Annual Charge | Final Value |
|---|
| Tracker | 0.75% | £71,800 |
| Shares fund | 1.5% | £63,100 |
| Fund of funds | 2.5% | £53,400 |
So over 30 years, the charges from our fund of funds will have taken off a whopping slice of £9,700 more than our shares fund, and an astronomical £18,400 more than our tracker. They really need to perform in the fast lane to justify that amount of pocket-lining.
But sadly, just as most share funds perform less well than a tracker (despite their touted stock-picking expertise), there is little evidence that the supposed fund-picker expertise behind a fund of funds brings in any better performance after charges either. So the only people who really benefit are the fund managers, trousering fat fees in return for very little in the way of results.
So, just as we saw how we're only likely to be looking at the luckiest funds by going on past performance, we're also only likely to do well with a fund of funds if we're lucky enough to pick one that’s lucky enough to pick the luckiest funds to invest in.
Or we could go for an index tracker, get the lowest management fees in the business (because the computers that do the automated stock-picking don't need expensive lunches or fancy braces and bowties), and keep a much bigger slice of the returns for ourselves.
>The Motley Fool's Share Dealing Service allows you to buy exchange-trade funds, which offer a low-cost way of tracking the market up and down. Buy and sell ETFs and ordinary shares online in real time for a flat rate of just £10. Open an account for free today. There is no obligation to trade.
