The typical index fund is run by a group of professionals who act as legal guardians and directors of that fund. Those individuals and/or their company have to make money. In order to do so, they charge management fees usually based on a percentage of each member's account balance.

Here's what you need to know: when your fund manager takes money from your account to pay for annual management fees, you instantly have less money to invest. That means your returns are lower until such time as you recoup what was taken out. Paying what might be considered excessively high fees can actually erode your returns over time.

Consider the following example offered by the Daily Mail's Holly Black:

You decide you can invest £15,000 in a fund offering a 5% return for ten years. One fund assesses an annual charge of 0.8% while the other charges 1.5%. After ten years, the first fund would be valued at £22,662 while you would have paid £1,772 in charges. The second fund's value would only be £21,006 with total charges at £3,427.

From this example, it's clear to see how less than one full percentage point can really make a difference in how charges affect returns. Bear in mind that the Financial Conduct Authority recently decided to take no action to cap fund charges, meaning there is still plenty of room for wide differences between funds.

It's All about Performance

We want to be clear in stating that higher management fees are not necessarily a bad thing. In fact, there is a certain measure of truth in the idea that you get what you pay for. Some of the best fund managers in the market charge higher rates because the returns they generate justify those rates. So it's up to investors to compare annual fees against the performance of the fund.

Under the fictional example offered by the Daily Mail, the first fund would be the obvious choice with all other things being equal. It might not be the best option if the second fund generated an average annual return of 7%. That higher rate of return would justify the higher fee of 1.5%.

Understandably, taking the time to learn the basics of investing is challenging in a world where we are all struggling to find enough time to do everything. But if you are investing, and you should be, it's important that you make the time to learn as much as you can about how it all works. The more you understand about investing, the more you will be able to absorb information and use it to make wise decisions.

Where index funds are concerned, pay attention to annual charges as compared to fund performance. If a fund's charges seem excessively high, make sure their average returns are worth it. If a fund's charges seem too low, consider whether or not that fund actually generates enough returns to make investing in it worthwhile. It's all about performance at the end of the day. A well-positioned fund will offer adequate returns with charges that are justified by those returns.

Sources:

  1. Daily Mail – http://www.dailymail.co.uk/money/investing/article-3793290/INVESTMENT-EXTRA-s-worth-paying-big-fees-funds.html
About Us
Alfred Maki

Founding Partner, Investment Strategist

Alfred is a global investment specialist with more than 20 years’ experience. Having started his career as a trader, Alfred has spent years learning the intricacies of the various markets including stocks, bonds, commodities, consumer financial products, property, and more.