As part of our focus on Evidence-Based Investing, I am currently reviewing literature on a range of investment topics. I want to share some of the interesting stuff I’m reading, and I will update the page from time to time.
I get a lot of flak for obsessing over the cost of investing – especially fund charges, as I happen to believe it’s very hard to justify the value. So, we’ll start by looking at the cost of investing – and contrary to what you might be led to believe, cost has a huge impact on client outcomes. I mean HUGE!
This one is a 2010 article based on Morningstar’s research into funds expenses and star ratings as predictors of future fund performance. The finding is really simple and best delivered in the researcher’s own words;
‘If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success..’
So, regardless of whether you pick active or passive fund, keep cost low! It is a far better predictor of performance than any analysis you could possibly do!
This article in June 2012 edition of the CFA Magazine is Charles Ellis’ attempt to present an alternative view of fund expense. Rather than looking at fund charges as a percentage of client’s invested asset, why not look at it as a proportion of the expected return from that fund? Better still, when viewed as a proportion of the excess risk adjusted return, over and above the market return (less cost of index fund), fund charges looks quite expenses. Ellis wrote…
Therefore, investors should consider fees charged by active managers not as a percentage of total returns but as incremental fees versus risk-adjusted incremental returns above the market index.
Thus (correctly) stated, management fees for active management are remarkably high. Incremental fees are somewhere between 50% of incremental returns and, because a majority of active managers fall short of their chosen benchmarks, infinity. And when market returns are low, as in recent years, management fees eat up even more of an investor’s return. Are any other services of any kind priced at such a high proportion of client-delivered value? Can active investment managers continue to thrive on the assumption that clients won’t figure out the reality that, compared with the readily available passive alternative, fees for active management are astonishingly high?’
I think the Investment Management Association could learn a thing or two there, iin their bid to make fund charges a bit more transparent and intelligible!
In this rather heavy technical paper, Nobel Laureate economist William Sharpe advocates the use of what he termed ‘terminal wealth ratio’ — a simple yet meaningful measure of the relative terminal wealth levels for those investing in funds with different expense ratios.
Under plausible conditions, an investor saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments, (even after accounting for possible outperformance by the fund with high expenses.)
He noted;
….with moderate amounts of active risk (tracking error/standard deviations of less than 2.5% a year), an investor in the low-cost fund will almost certainly be richer than an investor in the high-cost fund. Moreover, the disparity is likely to be very large. But there is a small chance that after 30 years, the two will have relatively similar amounts of wealth.
This one, from the grandfather of passive investing himself, is an attempt to take Sharpe’s paper even further by considering not only the annual fund expense but also cash drag, portfolio turnover and sales cost (platform charges, commission etc.)
Bogle estimates that these costs add 2.27%pa to the cost of investing in a typical active fund;
….when all-in costs—which obviously exist and are substantial, whatever their precise amount—are considered, the assumed retirement wealth accumulation enhancement provided by the low-cost index fund… leaps to fully 65% higher, ranging from 32% to 86% higher.’
He concluded with these words
‘Do not allow the tyranny of compounding costs to overwhelm the magic of compound.
The paper by the Pension Management Institute’s Debbie Harrison, Kevin Dowd and the esteemed John Blake looks at whether UK pension investors are getting good value for money. The summary of the paper makes an interesting read….
The total expense ratio (TER) is a key determinant of the default fund’s outcome, which we express as an income replacement ratio (RR) in retirement. Of the funds modelled, the default fund with highest mean Retirement Replacement (23.8%) was 55% higher than that with the lowest mean RR (15.3%). This was largely due to charge differences.
As a rough rule of thumb, each percentage point increase in the TER leads to a fall in the expected replacement ratio at retirement of about 20%, and to a somewhat smaller fall in the lower bound of the projected retirement replacement ratio.
While the investment strategy has an important impact on member outcomes, it is much less important than the impact of charges.
There is a notable trade-off between risk and return, but it is only the low- charge schemes that lie along the investible frontier. In other words, while ‘cheapest’ is not synonymous with ‘best’, there is no evidence that higher charges can ‘buy’ more sophisticated investment strategies that deliver superior performance
The paper seems to suggest that charges are more important than asset allocation and portfolio structure. However, bear in mind that the data used is mostly of default, multi-asset pension funds, which tend to be pretty static in their asset allocation and largely made up of closet indexers – i.e active funds charging high fees for largely tracking an index and very small active share.
The real juice is on Pgs 20 – 24, which details the mind-boggling layer of fees investors pay to the fund industry. You’are fooling yourselves if you think TER or OCF is all we pay fund managers!
Then turn to the second section of the report in Pg. 39 , which shows pension investors paying as much as 3-4%pa TER in some of the older funds. But while modern funds have lower headline rates, hidden charges on these newer could be as much as 50% more. Hard to believe that in 2014, fund managers and pension providers still get away with this sort of thing!
In Summary
‘It’s not about cost, it’s about value’
‘Clients don’t really care about cost’
I hear these sorts of thing a lot these days. My response to the first is… it absolutely is about cost! And to the second ‘well, they should!’
Investing costs are too important to ignore. They have huge impact of client outcomes – whether clients realise it or not is not the issue. If they did, they’ll want us to obsess about it all day along.
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Abraham, excellent article. Clients don’t care about costs because they don’t understand the impact – but advisers do (or at least should) which is why the client needs an adviser. Indeed, a professional adviser is one who is prepared to say to the client; “that’s too expensive, I can’t recommend it’. Isn’t whether a client ‘accepts’ an expensive proposition the ‘old way’ of doing business and now surely irrelevant?