Focus On Cost: What is the impact of fees and charges on returns?
For me, the cost of investing is one of the biggest issues — if not the biggest issue — facing the global financial advice profession.
As research by Morningstar has shown, cost is the single most reliable predictor of future performance. It's essential therefore that advisers have a thorough grasp of the different fees and charges involved, and the relationship between cost and performance.
This is the first in a series of six articles called Focus On Cost in which I'm going to be asking some key questions that advisers need to confront.
These are my opinions and doubtless others will have completely different views. But this is a very important debate for advisers to be having and, as always, I would appreciate your views.
Warren Buffett tells a story in his 2005 letter to Berkshire Hathaway shareholders which every financial adviser should read. It concerns a family he calls the Gotrocks, which owns corporate America and receives the full value of the profits earned by every listed company in the country.
All is fine until a group of people, which Buffett labels Helpers, offer to assist some family members to outsmart the others, "for a fee, of course". So, while the total profits generated by businesses and earned by the Gotrocks family doesn't change, they have to pay a share of it to their Helpers.
What do the Gotrocks do as their net returns decline? You’ve guessed it, they hire more and more Helpers, charging more and more fees, which inevitably results in the family’s share of the profits being eroded even further.
No magic shower of money
“The most that owners in aggregate can earn between now and Judgment Day,” says Buffett, “is what their businesses in aggregate earn. There is simply no magic — no shower of money from outer space — that will enable them to extract wealth from their companies beyond that created by the companies themselves.
“Indeed, owners must earn less than their businesses earn because of ‘frictional’ costs. These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.”
Pay for nothing, get everything
Buffett’s friend, the indexing pioneer John Bogle, makes the same point in The Little Book of Common Sense Investing. "The grim irony of investing,” writes Bogle, “is that we investors as a group not only don't get what we pay for, we get precisely what we don't pay for. So if we pay for nothing, we get everything."
Of course, investors can’t literally expect to pay nothing for a share of the proceeds of capitalism. Even those US investors who’ve taken advantage of one of Fidelity’s zero-fee index funds still have to pay a platform fee.
The important thing for the investor, and for their adviser if they use one, is to keep the number of Helpers to a minimum and dispense with the services of any intermediaries who aren’t adding at least enough value to justify the cost of using them.
Hundreds of Helpers
So how many different kinds of Helper are investors using, apart from their adviser? Let’s put it this way: the fund manager’s annual management fee is just the tip of the iceberg. Underneath are a whole range of implicit costs — transaction charges, custody charges, brokerage fees, foreign exchange fees and so on — some of which are very hard to pin down.
In a recent edition of Money Box on BBC Radio 4, Dr Chris Sier, the former policeman and statistician hired by the UK financial regulator, the FCA, to produce a cost disclosure code for the asset management industry, said he had identified several hundred fees and charges investors are unwittingly paying.
Every bip counts
What, then, is the impact on an investor’s net returns of paying fees and charges of 3.5% (which, remember, excludes the cost of any advice)? Well, if you invested £100,000 for 30 years, and assuming an annual rate of return of 6%, you would be left with £209,555*. You would have lost £364,594 of your return in costs.
That’s all very well, you might argue, but no one pays as much as 3.5% nowadays, do they? Actually, you may be surprised at how many do. But even with a total cost (including transaction costs, custody charges and everything else) of 1.5%, you would still be paying almost £200,000* — or nearly half — of your return to intermediaries.
Another objection which advisers raise at this stage is is the following: the whole point of hiring a fund manager is to try to deliver market-beating returns. It’s not about the cost, in other words, but about the value added.
Most funds subtract value
I’m going to be tackling this subject in more detail later in this series of articles. Suffice it to say for now that, over the long term, on a risk and cost-adjusted basis, only a tiny proportion of funds outperform the relevant benchmark index on a risk- and cost-adjusted basis. Dr David Blake at Cass Business School in London puts the figure at around 1%. What’s more, identifying in advance the funds that will outperform is very difficult.
In conclusion, we can only guess at how a particular manager will perform relative to the index, but one thing that investors do have control over is how much they pay. To quote Warren Buffett again, “performance comes, performance goes, (but) fees never falter.”
Advisers in the past have placed too much emphasis on short-term performance with no statistical significance and far too little on what their clients are actually paying to have their money managed. If they want to true fiduciaries — genuine Helpers, if you like — and act in their clients’ best interests, they need to redress the balance.
*Candid Money: Fund Charges Impact Calculator