This article looks at a very important topic:

Investing for your future

The reason I say very important is that in our experience some investors have either limited knowledge on the subject or a lack of access to enough information to help with their decision making.

When dealing with clients' money, we are very clear about the way in which we recommend they invest. This is based on a concept known as Modern Portfolio Theory, which uses passive not active funds.

NOTE: Passive funds do not employ the services of a fund manager, whereas active funds do.

Our clients are then rewarded by accepting the market return based on the risk they wish to take at a lower cost than many actively managed funds.

When meeting new clients they are often not aware of the historical failure (in terms of consistent performance) of many actively managed funds and the associated high costs.

As costs are the one thing we can control, we would normally illustrate these costs and how they eat into the real return they could expect.

Let's look a little further at these costs.

Ignoring trading costs for now (which is a cost based on how many shares the fund manager buys and sells in a year), below is an example of fixed costs of both passive and active funds.

James has existing investments made up of existing PEPs/ISAs/Unit Trusts totalling ??100,000.

The advertised costs would typically be:

? Existing active annual management charge ?C 1.5%

? Equivalent passive annual management charge ?C 0.9%

What we can deduct from this is that the active manager has to grow his fund by 0.6% per annum to equal the passive fund.

However, what is missing here and what fund management companies have to show (introduced recently), are the costs to trade the shares that are incurred in any one year.

Example

The average actively managed fund trades 75% of its holdings every year, and the average passive fund trades 15%.

Taking into account the annual fixed charges above, the effect of this takes the typical charges to:

? Existing active annual total charges ?C 2.85%

? Equivalent passive total charges ?C 1.17%

This is a massive 1.68% difference!

Other Considerations

We need also to bear in mind that a lot of funds trade more than this. For example, it is not uncommon for some funds to trade 100-300% rather than the 75% average.

This takes the costs to something like 3.3% - 6.9% per annum! (some 2.1% to 5.7% above the costs of a passive fund).

Exceptions

There are exceptions to the debate though.

There are a number of actively managed funds that have delivered consistent returns over the long term. Examples are Fidelity Special Situations run by Anthony Bolton and Neil Woodford who runs the Invesco Perpetual Income and High Income funds.

However, we cannot be sure that these funds will continue to prosper in the way they have, but we can be sure they will carry the extra expenses highlighted above.

The Financial Tips Bottom Line

Actively managed funds can be expensive, especially when you take ALL costs into account. As we can see, if a fund has a high ??trading percentage' the overall costs increase significantly.

If you use active funds make sure you request this information from your fund manager(s) and review your portfolio.

Recommended Reading

There is an excellent (readable) book that has recently been released on how to invest your money. "Smarter Investing" by Tim Hale, paperback, is available at amazon for ??10.99.

Copyright (c) 2006 Ray Prince