The Cost of Investment – Why It’s So Important

I recently read this article by Antony Williams of Evolve Financial Planning. We asked Antony permission to include it as the topic is very important and provides a great insight that you should bear in mind before investing any money on the stock market.

Over to Antony…

Users of index funds are often accused by active managers of missing out on huge potential returns.  We recommend index funds for the sole reason that we believe the odds are massively against active managers.  We are yet to come across anyone who can persuade us otherwise!

The simple reason for this is cost.

Given that there is ample evidence that cost is increasing in the active industry at the moment (the latest example being Old Mutual raising the cost of their Select Smaller Companies fund to 1.75% from 1.5%- 0.25% doesn’t sound like much but it’s actually a 16.7% increase!), it seems like an opportune time to remind readers just how important cost really is. 

If the market is taken as a whole, the return of the active managers must equal that of index managers before costs.  Once costs are deducted, since index funds charge significantly less than active funds, they must outperform as a group.

When discussing index funds, many people trivialise the impact of cost.  It is not untypical to hear people comment that a percent here or there is immaterial.  But bearing in mind most private clients are investing for the long run, this could not be further from the truth.

The fund management industry as a whole is very keen on the concept of the benefits of compounding and there can be no doubt that it is extremely powerful.  According to FTSE, if someone were fortunate enough to have invested £10,000 in the FTSE All Share when the index was launched in 1962, this would currently be worth a little over £308,000 representing a compound annual return of 8.3%. 

This is not an unreasonable timescale to consider. 

Most people start saving for their retirement in their twenties and may not draw an income until some time in their sixties.

However, it is important to realise that 8.3% is the return of the index and as costs are involved, few people would be fortunate enough to make this much.  Assuming an index fund has a cost of 0.5% per annum, the total return would fall to just under £253,000 showing how even modest costs have a significant impact over a long timescale. 

When the costs of active managers are taken into account the position is much worse.  Assuming total expenses of 1.5% per annum (which is on the conservative side), the £10,000 invested at the end of 1962 would only be worth £169,000.  This is a staggering 45% lower than the return of the index. £139,000 has been eaten up in costs!  Further information on the effect of costs over time is shown in the table below.

Effect of costs on a £10,000 investment, assuming a 7% growth rate and various levels of charges.

Charges  5 years  15 years  25 years  50 years
0.5% p.a. £13,701  £25,718  £48,277  £233,067
1.5% p.a. £13,070  £22,325  £38,134  £145,420
3.0% p.a. £12,167  £18,009  £26,658  £71,067

John Bogle, the founder of Vanguard, is particularly keen on measuring cost as a percentage of the equity risk premium i.e., the additional return required by an investor to compensate them for taking the risk of investing in equities as opposed to government bonds.  Put another way, it is the difference in the expected return of equities and a long-dated gilt.

If the expected return on the long term gilt was 6% and the expected equity return was 8%, the equity risk premium is 2%. If the cost of investment stands at 2% for an investor there would be no advantage to investing in equities since the long term returns after costs would be the same.

According to Legal & General, the current equity risk premium stands at 3.75%.  Assuming the average unit trust has total expense ratio of 1.5%, it accounts for a staggering 40% of the equity risk premium.  However, with a low cost index fund where the TER is only 0.5%, only 13% of the equity risk premium is consumed.

These costs of 1.5% p.a. are conservative.  According Lipper Fitzrovia in research published on 18 December 2006, the average active equity unit trust has a total expense ratio 1.63%.  Many investors will have a stockbroker or investment manager who charges a 1% management fee on top of this and then commission on buying and selling funds as well.  When we analyse portfolios, it is not unusual to have total expense ratios of around 3% p.a.

The direct consequence of this is that an investor holding active funds will have to take significantly more risk than an investor holding index funds if they are to achieve the same return over the long run.  Whereas the passive investor can afford to hold a reasonable buffer in fixed income to reduce the volatility, the holder of active funds will have less scope to do this as the equity component of his portfolio will have to work harder to keep up.

One area that has become of increasing concern to us is that of multi managers.  There are some very good managers out there who are cost-conscious, using ETFs and index funds as core holdings, however, the total expense ratios of most multi managers tend to be well in excess of 2% per annum, with some approaching 3%. 

According to the same research article from Lipper Fitzrovia, the average total expense ratio on multi manager funds stands at 2.2%.  Using the Bogle methodology, this accounts for almost 60% of the current equity risk premium.  If the average private client was told this, how many would really be prepared to pay these fees?

It is true that some multi managers are building globally diversified portfolios and hold both equity funds and fixed income and some people may argue that they deserve a premium for doing this.  However, the evidence does not show that they outperform their benchmark index.  

Investors should also be aware that low cost tools are becoming increasingly available to private clients through index funds and ETFs.  It is interesting to note that the new fixed income ETFs launched by iShares, have expense ratios as low as 0.2% per annum.

The Key Considerations

As sceptics of active funds, we are not claiming that active managers cannot do a good job and outperform for limited period.  However, we are comfortable on missing out on some of the potentially high returns made by such managers over relatively short timescales, with the knowledge that in most cases the tortoise will outperform the hare!

We do believe that markets are efficient, and therefore costs play a vital part in any investment strategy.  Anyone who thinks otherwise should check the numbers carefully!

ACTION POINT

Thanks Antony.

It’s more than likely that you have money invested in active funds, perhaps in a pension plan or ISA/PEP. We recommend that you take action and review your funds as investing your money as you’ve always done in the past may not be in your best interests.

Contact us to find out how we can help.

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About Ray Prince

My work passion is helping dentists and doctors strategically plan their financial futures in a totally impartial way (I work on a fee basis). Outside of work the best words that can describe me are: father, husband, keep fit enthusiast (running), family oriented, non-materialistic, enjoy new challenges, smiling, living by the coast :)