High costs and low returns don’t mix.
In the good times generosity abounds. Everyone gets to share in the spoils. Investors, fund managers and financial planners all make money. It is only when the good times stop investors sharpen their focus on the genuine value derived from fees.
The cost of investing
Fees and taxes act like friction on your investments. They slow down the compounding rate of return you can achieve. Where possible, it is imperative to minimise both.
There are generally three layers of fees in the investment industry. The fees will vary depending on amount invested; services offered; type of investment recommended and type of administration service. The following are indicative fee ranges offered by the investment industry:
- Financial planner: 0.5% to 1.% — note with the introduction of Future of Financial Advice (FOFA) on 1 July 2013, the percentage based fees have largely been replaced by a dollar amount monthly retainer e.g. $100 per month ($1,200 per annum). If you have an investment of $200,000 this equates to 0.6% of funds invested.
- Investment manager: 0.2% to 1.2%
- Administration: 0.3% to 0.5%
The total level of fees can vary from 1.0% to 2.7%. In my experience the average fee for the average client tends to be around 1.8% to 2.0%
Are investment managers value for money?
The theory is professional investment managers will more than justify their fees by outperforming the market.
As usual there is a difference between theory and reality..
The vast majority of professional managers measure their performance to a relevant index. A manager investing in the Australian share market’s Top 200 companies benchmarks its performance against the ASX 200 Accumulation index.
Professional investment managers undertake extensive company research to identify the winners and losers in the index. The managers aim is to back more winners than losers to deliver superior performance. This is easier said then done.
Investment managers suffering from Illusory Superiority Syndrome (above average effect) are inevitably brought back to earth by the performance tables.
The following chart from S&P Dow Jones Indices Report 31 Dec 2012 shows over a 1, 3 & 5 year period the percentage of investment managers who were outperformed by the index up to 31 December 2012.
In my opinion the Five Year column — a decent amount of time for a trend to be established — is the most relevant. With the exception of Large Cap Value Funds (and only by a very small margin), the majority of professional investment managers did not beat the relevant index.
The following extract from the reports Executive Summary (emphasis is mine) pretty much sums it up:
‘The performance figures are equally unfavorable for active funds when viewed over three- and five- year horizons. Managers across all domestic equity categories lagged behind the benchmarks over the three-year horizon. The five-year horizon yielded similar results, with large-cap value emerging as the only category that maintained performance parity relative to its benchmark.’
The above data is on the US investment industry. However, Morningstar Research has conducted similar studies on the Australian industry and produced roughly the same results.
While the data clearly indicates the majority struggle against the index, there are a select group who do consistently out perform the index.
Selecting these consistent outperformers in advance is not easy. The task doesn’t get any easier by using past performance either. There is absolutely no guarantee the results will be replicated.
How to play the percentages game
We know from the S&P Dow Jones table nearly 70% of investment professionals fail to beat their relevant benchmark.
The other major consideration is cost. There is a significant difference in the percentage charged to run an index fund and that charged by investment professionals.
Index funds employ computer models (not expensive analysts) to simulate the index.
Without the high cost of personnel, an Australian share index fund (Exchange Traded Fund) operates on a management fee of approx. 0.3% per annum.
The management fee for investment professionals — operating in the Australian share market — range from around 1% per annum (Wholesale) and up to 2% per annum (Retail).
Based on: a) The index consistently outperforms the majority of investment professionals, and b) Index funds operate on significantly lower fees, the question is, ‘Why wouldn’t you just invest in the index?’
If investors adopted this simple and logical approach, then nearly 70% of investment professionals would close their doors. The investment industry will not surrender this ground easily. This expains why marketing departments are an essential part of the industry.
The Return of the Secular Bear market
The Secular Bull Market of 1982 to 2007 delivered an average return (income + growth) over this 25-year period of 15% per annum.
With this level of return on offer, investors are happy to share the bounty and rarely question paying an all inclusive investment cost of 2% per annum.
It is a different story in a Secular Bear Market. Low single figure returns are the norm for Secular Bear Markets and paying 2% per annum strips away the majority of an investor’s return.
Only time will tell as to whether we have entered a Secular Bear Market or not, but it is reasonable to assume the sustained double digit market returns are a distant memory. Therefore the luxury of higher fees for lower performance is one you can definitely not afford (not that you should need a Secular Bear Market to highlight this fact).
In my opinion a prudent optimistic outlook for the future would be for a low growth, low return era in all major investment markets — shares, cash, fixed interest and property.
The more pessimistic outlook would see negative returns in risk assets — shares and property — and very low interest rates on cash and term deposits.
In either scenario, paying fees totalling 2.0% per annum seriously erodes your net returns.
Even if you disagree with my bleak outlook for growth assets, investing in index based ETFs compared to investment professionals makes sense from both a cost and performance perspective.
With the market conditions we find ourselves in, it is vital you reduce your friction to a fraction.
for Markets and Money
From the Archives…
Here’s WhyYou Should Beware the Financial Planning Mantra
31-07-2013 – Vern Gowdie
A Narcissistic Financial System
30-07-2013 – Greg Canavan
Living in a Keynesian Fictional Paradise
27-07-13 – Nick Hubble
Has the Chinese Economy Hit the Great Wall?
26-07-13 – Bill Bonner
Crisis, Capital Controls, and Accidents of Birth
25-07-2013 – Doug Casey