A 2 per cent fee may sound like small change, but over time this cost can significantly reduce the value of your investment, writes FIONA REDDAN.

IF YOU were given the option of investing in a fund but were told you had to give half of everything the fund made back to the manager, would you go ahead with your investment? Unlikely, isn’t it? Yet this is what many of us do every year.

Like anyone who offers a service, fund managers charge investors an annual fee for managing their money. But these fees eat away at your returns and, in some cases, can wipe out any upside.

For example, in a fund that yields 4 per cent, an annual management fee of 2 per cent will cancel out half of the returns. This means that if the fund makes €1,000, €500 will be taken back in fees.

If you are one of those people who invests in a fund with barely a glance at the fees charged by the fund’s managers, you should know that in some cases you are simply throwing money away.

While there is no guarantee that a cheaper fund will outperform a more expensive option, minimising your costs when investing is a good place to start.

The most common charge is an annual management fee, or “expense ratio”, which usually ranges from about 1 to 2 per cent.

While a fee of 2 per cent may sound like small change, particularly when markets are enjoying a bull run and your fund is securing double-digit returns, over time this cost can significantly reduce the value of your investment.

Consider the impact of such a fee on €10,000 invested over 20 years, with an annual average return of 5 per cent. At the end of the investment period, a fee-free investment would have yielded more than €26,000. However, with a 2 per cent fee eating away at returns, such an investment would be worth less than €18,000 after the same period.

In addition to the management fee, funds often charge other expenses. These include: an allocation rate, which is a charge before you invest as it only allocates a certain proportion of your investment into the fund; a redemption or exit fee, which is charged when you want to cash in your fund; an early encashment fee, if you withdraw from the fund within a specified timeframe; a monthly policy fee, which is usually a fixed amount charged each month, typically ranging from €3 to €6; and transaction fees for when you want to buy or sell shares.

Zurich Life charges an encashment fee if you cash in your policy during the first five years, starting at 5 per cent of the value of your policy if you do so in year one and falling to 1 per cent in year five, while RaboDirect charges 0.75 per cent on entry and a further 0.75 per cent on exit.

Add these costs up and you could be spending more on keeping the fund running than the fund is making for you, particularly given the poor returns of late.

RaboDirect, for example, offers the Henderson Horizon Pan-European Equity Fund from Henderson Global Investors, which charges a 0.75 per cent entry fee, a 1.2 per cent management fee, and a 0.75 per cent exit charge.

If you invested €10,000 in this fund and held it for 10 years, assuming an annual 5 per cent rate of return, at the end of the 10 years your investment would have grown to €16,288.94. But when charges and fees are added, the value of your investment drops by €2,035.70, (€1,633.45 in fees and €402.26 in earnings foregone) to just €14,253.24.

The fund’s charges would effectively have wiped out a third of your returns.

Some funds are considerably more expensive. Take Friends First’s currency fund, which is aimed at more sophisticated investors with upwards of €50,000 to invest. It has put in a strong performance since its launch eight years ago, pulling in average returns of more than 11 per cent for each of the past two years.

But in addition to a set-up charge of 2.5 per cent of the investment and an annual management fee of 2 per cent, it also charges a performance fee for when the fund’s performance exceeds a threshold of 7 per cent per annum before the management charge.

This fee is 20 per cent of the amount by which the annualised fund growth exceeds this threshold, or 20 per cent a month, once the growth rate exceeds 7 per cent a year.

So while returns may be strong, they will be hit by high fees.

Fees really begin to hurt when your fund is losing money, like in the present environment, as they must be paid regardless of whether the fund is making money.

Bank of Ireland’s Balanced Managed Fund charges a 1.5 per cent annual management fee, but in the year to March 31st, it fell by 5.4 per cent. If you had invested €10,000 in the fund in March 2008, you would have lost €540 over the 12 months, as well as owing about €140 in fees, bringing your total investment down to about €9,318.

If you had simply kept your money on deposit earning 4 per cent, you would have come out of it with an additional €400 in your pocket.

Fees and charges on putting regular savings into equity or bond products can also hinder your investment’s growth. At Quinn Life there is no charge on regular contributions, just an annual management fee of 1 per cent, but this is not the case at other providers.

At Zurich Life (formerly Eagle Star), its Savings Plus products have a host of charges in addition to a management fee of between 1.25 and 1.75 per cent, including a 5 per cent allocation fee.

This means that just 95 per cent of your money is invested at the start, while a fee of €3 is deducted from the fund each month. It is also index linked, which means it will increase in line with inflation.

At Bank of Ireland, a charge of 5 per cent of every contribution up to €12,000 a year made to its Smartchoice fund is imposed, falling to 3 per cent if you invest more than €12,000 a year. In addition, there is a management fee of 1.5 per cent a year.

So, if you invest €300 a month, you would have earned €4,369.43 at the end of five years with Quinn Life, including €225.18 in fees and earnings foregone.

Zurich’s higher charges would mean your investment would be worth at least €314 less, while you would be worse off to the tune of €322 if you had gone with Bank of Ireland.

However, this is assuming an average annual growth rate of 5 per cent and the more expensive funds may perform better, reducing the impact of higher charges.

Fees are an even more important consideration when choosing a bond fund, as returns are generally lower – albeit more stable – than equity funds. In other words, high fees in a bond fund will gobble up a greater proportion of returns.

The Robeco All Strategy European Bonds fund offered by RaboDirect has an annualised rate of return of 1.79 per cent for the past five years. But with an annual management fee of 1 per cent, plus an entry and exit fee of 0.75 per cent each, your returns would have been almost cancelled out in both the first and last year due to fees.

When performance is not guaranteed, it clearly pays to shop around for the only thing that is guaranteed: fees and charges. But what are the options?

Actively managed funds, whereby the fund manager aims to out-perform a specific benchmark or to “beat the market” by regularly buying and selling stocks, are generally more expensive than their passive counterparts, which track indices such as the SP 500, FTSE 100 or Iseq. Active funds also generally have a wider scope of investment opportunities.

However, although some active funds do outperform the market, not all of them do. Not only are passive index funds a lot cheaper but in many cases they are as effective when it comes to generating returns. Moreover, many managers of active funds are so scared of lagging the market that their portfolios end up looking remarkably similar to funds that simply track indices.

In the US, John Bogle’s Vanguard revolutionised the mutual fund market when it introduced index-linked funds, which track the major indices.

With fees starting at just 0.18 per cent for the first index fund, the Vanguard 500 Index, Bogle’s firm has become a favourite with US investors.

The firm launched a range of funds for the UK market last month with keenly priced products such as the FTSE UK Equity Index Fund, which charges an annual fee of just 0.15 per cent.

The funds are not available in Ireland, however, and, as you might expect, while other index funds are available here, the charges are higher.

Quinn Life is one of the main providers of such funds. Its charges, which range from 1 per cent to 1.5 per cent, are some of the lowest on the market but they are still up to 10 times higher than Vanguard’s UK products.

While Quinn Life attributes the higher charges to the fact that there are fewer economies of scale in the smaller Irish market than in higher-populated areas such as the US, it does mean Irish consumers are missing out.

For example, on an investment of €10,000, in terms of fees and earnings foregone, Vanguard’s fund is cheaper than its Quinn Life UK counterpart by more than €1,300 over 10 years. Nevertheless, it still makes sense for Irish consumers to shop around for index funds, as significant differences in fee structures exist.

Bank of Ireland’s Eurostoxx 50 Fund tracks the eponymous index and charges a 1.5 per cent annual management fee, while Quinn Life’s Euro Freeway Fund tracks the same index but charges just 1 per cent. Best of all is Irish Life’s Indexed Europe Fund, which has an annual management fee of 0.4 per cent.

If you had €10,000 invested with Bank of Ireland (over 10 years, annual return 5 per cent), the cost to you would be €2,284.84. At Quinn Life it would be €1,557.52. At Irish Life it would be just €639.95. As each fund will perform the same, it makes no sense to pay more for your management fee than necessary.

An alternative to index-linked funds is exchange-traded funds (ETF), which also offer low fees. Again, though, fees are considerably higher for Irish investors.

The norm internationally is to charge about 0.5 per cent annually, but the Iseq 20 ETF, which tracks the largest Irish stocks, has a management fee of 0.75 per cent. Another source of cheaper funds is Investandsave.ie. It offers a range of 26 funds, both actively and passively managed by Zurich, and charges only an annual management fee of 1 per cent.

Finally, what should you do if you have money invested in expensive underperforming funds?

Now is not the time to cash in as, with share values on the floor, you would be crystallising significant losses.

Rather, you should consider reallocating any new funds you wish to invest in a cheaper option and, when markets have improved to a level at which you are happy, you could then consider cashing out existing investments.