It’s a debate I hear about often. Countless times in fact. So much so I wrote a research paper on this topic: Should an investor simply use a passive investing approach when selecting funds, or use active management strategies too?

I’ll not rehash my old research here. Instead, I’ll focus on the impact of fees and show how a seemingly small 1% Ongoing Charges Figure (OCF) can add up over the years. But if you find a good active manager, it may still be worth paying the higher cost versus a passive investment fund.

So should you simply rely on passive investing, or pay up for some active funds instead? Let’s find out.

An Introduction to Fees and Funds

Before I get onto the topic of fees, let’s recap what a fund is first. A fund is a way to pool investor money, and then for a fund manager to invest that money in a certain way.

It could be to buy UK stocks, or corporate bonds, just to name two examples. The fund manager can attempt to outperform a market index, like the FTSE 100 in the UK, which means the fund is using active management.

Alternatively, the fund manager simply attempts to replicate whatever the market is doing. So using the FTSE 100 as the example again, it would be to replicate whatever this index does, rather than trying to outperform it. This is passive investing.

I’m going to refer to a specific type of fund in this post, known in the UK as an open-ended investment company, or OEIC (typically pronounced ‘oik’). The common name for these funds in the US is a mutual fund.

Now onto fees. As the acronym OEIC implies, these types of funds are actually investment companies, whereby the company’s business model is to invest money on behalf of its investors.

I’m speaking very basically here, but hopefully you get the idea. I’ll leave the rather detailed discussion on prospectuses, FCA authorisation, KIIDs and other tedious acronyms for another day.

For today’s post, I want to dig into fund fees and why we pay them. Let’s start with the Ongoing Charges Figure, OCF, which I mentioned earlier. This is the all-in fee we must pay when we buy a fund.

It’s priced as a percentage, say 1%. So, if we invest £1,000, we pay £10 each year assuming no growth of the investment amount. But what are we paying for?

Well, quite a lot of things actually. These funds, or investment companies, must pay FCA fees, depositary fees, trading fees, staff including the fund manager(s), legal fees, and so on. The OCF covers all of this.

Commonly, you’ll also see an Annual Management Charge (AMC) quoted which will be less than the OCF. This AMC is what the fund house takes as revenue to pay for things such as staff and other company costs (like marketing the fund), while everything over and above the AMC pays for things like the FCA, legal and depositary fees.

But how is the fee actually taken? Remembering the 1% OCF on the £1,000 investment, totalling a £10 charge, investors don’t get an invoice for this, or have to set up a direct debit or anything. It’s taken out of the investment amount. Essentially, it’s skimmed off the top of the money held within the fund.

Very basically then, the larger the OCF, the more money that’s taken from the investment pot. To compensate for this, investors require higher returns.

The Impact of Fees

Let’s explore the impact of fees a bit further. The best way I’ve found this described was by Terry Smith of Fundsmith, where he highlighted the drag on investor returns by “Two and Twenty.”

As a quick introduction, Terry Smith is perhaps the most well-known fund manager in the UK today. He is the lead manager of Fundsmith’s flagship fund, Fundsmith Equity. The fund itself is huge at over £24bn at time of writing, and is set out to manage investor money in a simple way:

• Buy good companies
• Don’t overpay
• Do nothing

Investing seems really easy when you put it like that. More on Fundsmith Equity later. But for now, back to fees.

So what’s Two and Twenty? This is a typical fee structure for a hedge fund. The Two means a 2% OCF essentially, or 2% charge on the money invested in the hedge fund. The Twenty means that the fund manager takes 20% of the profits generated by the fund manager.

Seem reasonable? Although 2% is double the 1% I used as an example before (so a £20 charge on £1,000 invested, rather than £10), the Twenty is only charged if the fund manager generates a profit for us investors.

Time to use Terry Smith’s brilliant example to show the impact of Two and Twenty.

Using Warren Buffett’s 45-year investment performance of a 20.46% per annum return, which is quite amazing, he calculates that a $1,000 investment in Buffett’s company Berkshire Hathaway in 1965 would be worth $4.3 million by 2009.

He clarifies that this is because Buffett runs Berkshire Hathaway like a company and invests alongside its investors, implying that there is no Two and Twenty charging structure.

What if you had invested in a Two and Twenty hedge fund instead? Well, the $4.3 million gain from above… would be reduced to only $300,000.

I say ‘only’ relative to the $4.3 million, as turning $1,000 into $300,000 is still pretty good. But $4 million of that gain when straight to the fund manager because of the Two and Twenty fee structure. Remarkable.

It’s clear, then, that fees matter.

Testing the Impact of Fees

I want to bring this back to reality a bit. Not many of us are going to be considering a Two and Twenty hedge fund given how most are for high-net worth investors, and are largely private vehicles and therefore inaccessible.

So I’ve put together a simpler example. For most of us, we’d be considering a passive investment fund, say to replicate the performance of the FTSE 100 index, versus an active investment strategy that attempts to outperform this benchmark.

Without picking exact funds at this stage, we may find typical active equity funds charge a 1% OCF, and a passive equity fund might charge a 0.1% fee. What happens to a £1,000 investment if both of these funds generate a 10% return per annum, using again the 45-year period? Take a look at the below chart to find out.

As you can see, the passive fund outperformed the active fund because of the impact from the higher fee. The difference between the strategies was £23,300 after 45 years, using the same period as Smith used to benchmark Buffett against the Two and Twenty hedge funds.

Or in other words, the investor paid the active fund manager £23,000 more over 45 years in comparison to the passive investment fund.

This is a much-simplified example though. The main simplification being that each fund generates the same 10% return each year.

Of course, if you’re an active fund manager, your goal is to outperform the passive funds, and not perform in line with them.

With this in mind, I’m going to check how Terry Smith has done.

Benchmarking Passive Investing and Fundsmith

Given that Smith has been so vocal about fees in the past, it’s only fair to use his flagship fund as a comparison here.

We touched on Fundsmith Equity’s strategy before, but just to provide a bit more detail, it invests in global equities on a long-term basis. This is why it quotes a benchmark index of the MSCI World, priced in sterling, that it tries to beat.

In terms of Fundsmith Equity, the share class I’m going to use is the T Class Accumulation. It charges an OCF of 1.04%, so very similar to the example I used earlier.

For the passive investing approach, I’m going to use the iShares MSCI World ETF hedged to sterling. The cost of this passive fund is 0.55%, which is on the pricey side but that’s in part related to the hedging costs back to sterling.

Nevertheless, it provides a suitable alternative for investors in the UK if they didn’t want to pay the higher fee for Fundsmith Equity.

Here’s the performance of the two funds since Fundsmith Equity was launched on 1^st November 2010:

That’s quite a difference, even though the passive fund charges almost half as much as Fundsmith does.

To put some figures on it, Fundsmith Equity generated a 597.74% return to the end of February 2024, while the passive fund returned 244.05% over the same period.

Or in pounds and pence: an investment in Fundsmith turned £1,000 into £6,977.40; investing in the MSCI World ETF turned £1,000 into £3,440.55. So more than double in Fundsmith.

Now I could have guessed the direction this was going to go in because I’m familiar with Terry Smith’s fund and know it has performed well over the long term.

The difficulty for investors is picking good active funds ahead of time, because not all of them perform like Fundsmith has. Many even underperform the wider market, and you pay higher fees for the privilege.

And even once you’ve picked a good one, the next challenge is holding it over the long term. We can see in the chart that Fundsmith Equity had a particularly tough time in 2022. Holding onto a fund when its falling is always difficult.

But to conclude, it’s good to be mindful of fees, but not obsessive over them. Yes, they make a difference, particularly if you’re paying Two and Twenty or similar.

But a good mix of active managers, and the use of passive investing funds as well, is likely the best approach to building a diversified portfolio.

I always say: be cost conscious, not cost obsessed.