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The impact of costs on your investment results

So, last week I wrote about the dangers of passive investments and I received a lot of comments along the lines of: Does that mean we need to change our investments.

The point was simply that, while passive investing is a very sensible LONG TERM strategy, there are times, when active management (as a group) is more likely to get better results than passive investing - particularly when so much capital is consolidated in so few (large cap) stock in the index. This, of course, is referring to market capital weighted index funds and ETFs.

The long term benefit of passive index investing for the investor that does not consider themselves an expert at stock picking, are undeniable over long periods of time:

If you look at the overall fees you pay for an actively managed fund you probably look predominantly at the "total expense ratio" (TER)

which covers the fund company's investment advisory fee, its administrative costs for stuff such as postage, record keeping etc. A typical fund will have a TER of 1%-1.5% pa. However, this is NOT all the costs you incur (and this is why the regulator is currently looking closely into the total costs and how they are revealed!)

A few years back, Forbes did a study into this and estimated the typical "transaction costs" (all those commissions your fund pays whenever it buys and sells stocks) to be about 1.44% p.a. On top of it you have the "cash drag" (the part of your funds a fund manager is keeping as cash (in order to fulfil redemptions etc), which Forbes estimated to be 0.83%.

So, if you hold the typical actively managed fund, you're looking at 3.17% per year.

Now, the number may still look relatively small, but becomes massive over the years, when compared to the typical market cap weighed index ETF.

Looking at it another way: The fund that charges you 3% per year is 60 times more expensive than an index fund that charges you 0.05%.

In other words: you go to the pub with your friend. Your friend orders a pint of their best and pays £4.00. However, you would be happy to pay 60x as much: £ 240!!!

Sounds ridiculous?

Lets consider the following example: David & Lisa.

Both are 35 years old and each of them has savings of £100,000, which they intend to invest.

Over the next 30 years, both achieve a gross return of 8% per year (not easy in current economic climate!)

Lisa invests in a portfolio of index funds, which costs her 0.5% p.a. in fees.

David does the same by owning actively managed funds that cost him 2% per year (notice that this is lower costs than the typical estimate by Forbes).

By the age of 65, Lisa has seen her fund grow from £100,000 to close to £865,000. As for David, his £100,000 has grown to £548,000.

Both of them achieved the same rate of return (8%), but they paid different fees. Lisa has 58% more money in her fund, an additional £317,000.

So, if you pay the extra fees, you would reasonably expect to get some extra performance for your money, right?

One of the best studies on this topic was undertaken by Robert Arnott who studied all 203 (US) actively managed mutual funds with at least $100m of assets under management, tracking their returns for the 15 years from 1984 through to 1998.

Shockingly, only 8 of those 203 funds actually beat the S&P 500 index. Fewer than 4%!!!

Looking at it from the other side, 96% of these actively managed funds failed to add any value at all over 15 years.

To better illustrate this point: Imagine you are in a game of black jack and you hold already 2 cards, say a jack and a queen. The gambler in you is shouting "hit me", but you know there are only 4 aces in the stack of 50 cards left, or a 1 in 25 chance to get the ace.

These are better odds than finding the fund manager that outperforms the market over the long term! Ouch!

With these odds, why would I bet on my ability to identify the tiny minority of fund managers who'll outperform over many years?

Im not encouraging anybody to time the market, as that is a looser's game.

If you have invested in index funds over the past years, you should be sitting on a tidy profit, providing you with a fair margin, even if the markets retreat in the short term.

However, if you are considering investing at this point in time, there may be a case for looking at factor weighted (not market cap weighted) indices and/or active fund managers in the near term, if you believe that markets are closer to full value and may retract in the short term, as active managers do not have to invest more money into companies whose price (market cap) has already shot up.

If you are investing for very long periods, i.e. 30 years plus, the costs of investing tend to play a dominant role and you are better off considering low cost funds, incl. market cap. weighted ETFs.

As always, if in doubt, consult your financial adviser for more details. I can only give general guidelines on how to look at your own investments yourself.

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