Hollow promises

"Active" managers justify their fees by promising to select the right shares and beating or outperforming the market in which they invest. However, for most managers, the promise is a hollow one.

The latest confirmation of just how hard it is for funds to earn their fees comes from research house Mercer. In its latest fund performance survey, the median-performing manager in Australian shares produced a return for the year to July 31 of 3.1 per cent, or just 0.1 of a percentage point better than the S&P/ASX 300 index's return of 3 per cent. And that's before fees. Once fees are removed, the median-performing manager underperformed the index. Exactly by how much will depend on the level of the fees.

THE LONG TERM

Anyone going into a share-based fund on an investment horizon of one year should not invest in shares in the first place. Over a five-year period, Australian share fund managers did better, with the median performer returning 3 per cent compared with 1.9 per cent for the S&P/ASX 300 Index. That's an outperformance of 1.1 percentage points, before fees. Assuming a fee of about 1 per cent, which is typical for actively managed Australian share funds, and deducting the fee from the returns, about half the funds have underperformed the market. Total fees are likely to be even higher, however, as investors will access the fund through administrative "platforms", which will have their own fees.

For investors, there are additional problems in picking a winning manager.

Research has shown that best performers in the past five years are often the worst performers during the preceding five years.

INDEX FUNDS

It is little wonder, then, the index funds have increased in popularity with investors. They match or mirror sharemarket returns and have total fees that are less than 1 per cent, though the investor is guaranteed never to receive investment returns that are better (or worse) than the market. They are cheaper than actively managed share funds because they do not have to pay the big salaries to stock pickers or the costs of researching potential investments.

An even cheaper way of capturing the returns of the market is through an exchange-traded fund (ETF). These trade just like shares and their returns will match the market they track. There are ETFs that track sectors of the markets such as "financials" and "resources" - as well as overseas sharemarkets and sectors - and commodities markets.

"Passive" investing, where the fund only buys and sells securities if the index composition changes, is more tax-efficient than "active" managers, who are buying and selling securities to beat the market. A lot of an active manager's gross return can be lost in tax on realised capital gains from portfolio turnover.

LOW COSTS

ETF management costs are usually less than 0.5 per cent a year. The investor will be up for brokerage each time units in an ETF are bought and sold. Brokerage will cost about $25-$70, depending on whether an online discount broker or full-service broker is used. The cost of brokerage makes it too costly to drip-feed money into the ETF. With managed funds, including index-tracking managed funds, the investor can start a savings plan, where regular amounts of money can be added to the fund. An advantage of managed funds over most ETFs is that the distributions from a managed fund can be automatically reinvested.