One thing, among others, that investors need to exercise caution with when wading into the IMA's "managed" sectors" is costs.* Many of these offerings are fund of funds, and some of these layer on absurd levels of fees over and above those charged by the underlying offerings. In the Balanced Managed sector alone, we count 37 funds with TERs north of 2%, 18 with TERs above 2.5%, and --schockingly, six that actually carry TERs greater than 3%. That's a ludicrous amount of money to pay in ongoing costs for a fund, and will seriously hamper performance. The six that charge more than 3% include CF Williams de Broe Balanced Managed Growth, CF Rowan Portfolio, Thames River Balanced Managed, Way Global Blue Portfolio, Snowdonia Balanced, and Marlborough Balanced.

Now, one could argue that balanced managed funds have more scope to add value via asset allocation than single asset class funds do and that they can thus more easily justify higher fees. We believe this, but only to an extent. That’s why, for a really good manager, we might be willing to go as high as 2.5% on a multi-asset fund. I stress the word "might", because when you pay that much money, the odds are really stacked against you. Think of it this way: Even the very best active managers have trouble adding more than a few percentage points per year at most (and we're being generous here) versus reasonable benchmarks. If three percentage points of the value-add is eaten up by ongoing costs, that's a huge hurdle to overcome.

Don't take my word for it, though. We can look at the data. If we take the funds in the Balanced Managed sector with TERs above 2% per annum, we get an average annualised return of -0.6% over the past three years through 30 September. If we look at the cheapest funds, we get an annualised three year return of 1.1%. We can't prove causality here, but more systematic studies have shown similar correlations. There isn't good historical TER data available on UK funds but our studies in the US have shown systematically just how much TERs can influence performance. Morningstar's US Director of Fund Research Russel Kinnel examined the matter in depth earlier this year--he went back and looked at whether buying the cheapest funds in a given peer group would increase your odds of beating the lowest-cost index offering in that peer group over the ensuing 10 years.

The results were telling--among US equity funds, simply buying the average fund in the cheapest quintile would have increased your odds of beating the cheapest index fund by 2.5x relative to the most expensive quintile, by 1.7x relative to the next most expensive quintile, by 1.6x relative to the middle cost quintile, and by 1.4x relative to the second cheapest quintile. The results for bond funds were even more pronounced, with simply choosing the average fund in the cheapest quintile increasing your odds of success by a staggering 6.9x relative to the priciest quintile.

Whilst we understand the appeal of outsourcing asset allocation to the experts, and believe there are reasonably cost-effective ways to accomplish it, advisors and their clients still need to be cognisant of the impact of charges over time. Otherwise, both risk having a poor long-term investment outcome.

*In the article, “Costs too High in Balanced Managed” published on October 06, 2008, by Morningstar, it was stated that Fitzrovia (TER) data leave out fees on underlying funds for funds of funds. This is true of their standard TER calculation, but due to an inadvertent omission the article should have noted that Lipper/Fitzrovia do offer UK fund-of-fund TERs that are inclusive of underlying fees as a separate service. Morningstar regret the omission.

A version of this article previously appeared in Investment Adviser, Financial Times Ltd.