Low-cost funds don't have to mean low returns

Administrative charges aren't as high as those that come with traditionally managed funds, but can they beat the market? Emma Dunkley reports

A low-cost active fund is supposed to be a little like getting Waitrose quality products at Aldi prices.

You get all the advantages of specialist fund managers and their teams shifting through the good shares from the duds but at a comparatively lower cost than a traditional managed fund.

However, are these low-cost funds the real deal or just yet another exercise in marketing hype? And does the old maxim that you get what you pay for hold true in fund choice as in nearly every walk of life?

The two ideals that spring to mind when you plan to put your money in a fund are high returns and low costs. You want to see your investment rise more than the market, but at the same time, you do not want to have your cash eaten away by large fees. On the other side of the coin, if opting for funds with low charges you may find yourself yearning for higher potential returns.

So how can you beat the market on the cheap? In the past six months, both JP Morgan and Schroders have launched low-cost funds run by managers. The Schroders UK Core fund, for example, is managed by an experienced team and has an overall charge, or total expense ratio (TER), of 0.40 per cent. Compare this with a TER of 1.70 per cent for the average UK fund and the cost saving is clear to see. To add to the low-cost attraction, the Schroders fund has no initial charge, no performance fees and no exit charge.

Yet, as the old adage goes, if it sounds too good to be true, it probably is. You might wonder if these funds can actually beat the market for such a low cost. The UK Core fund aims to return 1 per cent above the market, or the FTSE All Share index, each year after the 0.40 per cent charge.

Robin Stoakley, the managing director of UK intermediary at Schroders, says he believes these funds offer a chance to outperform the market for a low price. "These funds are not designed to provide the same returns as a typical active fund," says Mr Stoakley. "This is one that steadily beats the market each year."

However, some doubt whether these funds can beat the market, and question the point in buying one when you can invest in a fund that provides much higher returns. Darius McDermott, the managing director of Chelsea Financial Services, says: "If these low-cost funds are charging only about 0.40 per cent, they can't be offering much more return than the market."

He says in a 10-year period, higher cost funds run by well-known managers such as Richard Buxton or Anthony Bolton have significantly beaten the market, with the UK's top funds returning as much as 170 per cent over this time.

And if you do not want to pay high charges but still need a return in line with the market, index tracker funds or exchange-traded funds (ETFs) are lower in cost. The db-X-trackers FTSE 100 ETF has an overall charge, or TER, of 0.30 per cent, while the Vanguard FTSE UK Equity index fund has a charge of 0.15 per cent.

David Norman, the joint chief executive of TCF Investment, says if you have a choice of a lower cost product or one with higher charges, go for the cheaper option as cost is one of the biggest risks of investing.

But if you think these low-cost managed funds work like index trackers or ETFs, think again. Ben Seager-Scott, a senior analyst at Bestinvest, says: "These funds are actively managed, and unlike trackers or ETFs they do not have to hold a stock if the manager does not want to invest in it."

This means your low-cost fund could lose more, or gain more, than the market. So if you can buy a more expensive fund which offers higher returns, or buy a cheap tracker fund which still performs in line with the market, why invest in one of these low-cost active funds?

It is not necessarily the case that index trackers or ETFs will give you at least a return of whichever market you want to invest in. As these products also have charges and trading costs they eat into any gains that were in line with the index, meaning you will not get exactly the same return as the market. Mr McDermott says: "While there's a lot to be said for cheap tracker funds, there you will underperform because the charges still have to be taken out."

In addition, it is worth noting that the ETF industry is itself not without controversy. A fortnight ago the Serious Fraud Office said that it had identified ETFs as "an area of potential concern". The SFO's interest relates to the potential fraudsters have to set up bogus ETFs, investing in precious metals and commodities. However, the SFO was at pains to say that ETFs sold by mainstream banks and fund management groups weren't, as yet, a concern.

Unlike managed funds, index trackers and ETFs simply tend to follow market movements, whereas a manager can select which stocks they find attractive and have less exposure to, or leave out certain stocks which they find unattractive in a market.

Mr Stoakley at Schroders says: "Investing in an index fund is actually higher risk because it means allocating to the size of the company rather than its quality. What is better: an arbitrary group of stocks based on size, or a fund manager with conviction who can pick quality stocks?"

Indeed, these low-cost active funds are not designed to offer soaring returns but steady and consistent growth. By holding a greater number of stocks compared with the more actively managed higher-fee funds, the JP Morgan and Schroders products could offer a smoother ride in providing returns.

But even if these low-cost active funds do offer to beat the market, or at least return more than trackers and ETFs, what other advantages can they really provide? One big advantage is they will likely have a positive knock-on effect by making other funds cheaper. Mr Norman says: "If these low-cost funds drag down the fees in the overall marketplace, investors get more back, so this is a good thing."

Not only that, but Schroders and JP Morgan have clearly broken down the cost of the fund, so you can see where your money is going. For example, Schroders UK Core has an annual management charge of 0.35 per cent, while the remaining 0.05 per cent goes towards administrative costs, making the TER 0.40 per cent.

The JPM UK Active Index Plus has an annual management fee of 0.25 per cent and administration expenses of 0.15 per cent. The fund also has a fee for when it beats the FTSE All Share index, taking the total cost up to 0.55 per cent.

So if you are seeking a fund which is cheap and offers a return that could beat the market by about 1 per cent, these new low-cost funds are an option. But as Mr McDermott says: "If you want to buy the market, buy a cheap tracker, or if you want active fund management and want to get a lot more than the index, go for a manager with a track record of outperformance."