3 things you should know before you invest in a fund manager or LIC

With the proliferation of both managed funds and listed investment companies or trusts (LICs/LITs) like Forager AU Units (ASX: FOR) or WAM Capital Limited (ASX: WAM), investors that want their money managed are increasingly spoiled for choice.

Here are 3 things to help get you started:

Are you buying a fund, or a fund manager?

For example, Perpetual Limited (ASX: PPT) is the management company behind each of its managed funds. It grows predominantly from growing its funds under management (FUM) – the more money it manages, the more fees it earns on that money. If it is mismanaged, for example if it sells terrible products (funds), investors could exit its funds, Perpetual’s FUM could fall and it will earn less management fees.

By contrast, the Perpetual Australian Share Fund is a managed fund. You give your money to the manager, they invest it in shares, and aim to generate investment returns over time. You pay a management fee for this. However, you do not own a share in the business, so if Perpetual the fund manager becomes incredibly popular and starts earning more management fees, this will not have any impact on your returns. If anything, your returns may fall as a fund becomes more popular, because it becomes harder for the fund to invest all its money as it grows in size.

What is the management expense, performance fee, and cost ratio?

This is crucial for any sort of managed investment you take, although the specifics can vary quite widely. For example, an investment company will have fixed expenses like staff, rent, and so on that it must pay. Then it may charge a management fee as a percentage of the assets that it manages – say 1% per annum. On top of that it will likely charge a performance fee, perhaps 15% of any performance above a benchmark.

The fixed expenses ratio (also known as the ‘cost ratio’) can be very important with small investment companies, because it may cost say $300,000 per annum to employ a small staff and run an office. If the company is only managing $20 million, that works out to be a 1.5% fee, before any management and performance fees are charged. The cost ratio is not always easy to find so it may be worth calling the company to ask before investing.

What are the benchmarks?

The benchmark is vital. You want a fund that aims to beat a stock market index like the ASX200 over time. However, some funds benchmark themselves against the cash rate. This is a concern because cash returns are generally thought to be around ~4% through the cycle. If you are taking the risk of investing in equities (shares), you want to aim for an ~8% return or more. A low benchmark means that the manager earns more fees, and sooner.

For illustration, if the benchmark is the cash rate (2%) and returns per annum are 6%, performance fees of 15% chew up 0.6% (i.e., 15% of the 4% above the benchmark) of your performance every year. This means that one tenth of your overall returns could be consumed by performance fees, and on top of that you’re not even getting expected equity returns of 8% and above.

These are generalisations, as the funds management industry is quite diverse. However, picking the right investment manager is a crucial financial decision, and hopefully these tips will help you get started.

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Motley Fool contributor Sean O'Neill has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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