This is the third post in a series of three on the factors that determine how much we can expect to make from investing. The first post covered how our risk tolerance affects our returns, the second post explored how our time horizon affects our returns, and this post covers how the fees we pay affect our returns. It’s the intersection of all three factors that determines our ultimate returns. For an overview of the posts on this blog, please refer to the guide.
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An investment manager takes a client out for an expensive lunch, and the time comes to settle the bill. “Who’s paying for this, then?” the client asks.
The manager replies, “Me, in the short run”.
The power of reverse compounding
Having seen the power of compounding in my previous post, it’s also important to understand that compounding works in reverse too. Fees are the enemy of compounding, as the more you pay in fees on a portfolio, the less you have to compound into the future.
Total fees tend to range from between 0.75% of the portfolio’s value per year for a cheap robo-advisor, anywhere up to around 3% for a financial adviser using an investment manager investing in more expensive funds. Whilst the fees may sound small in percentage terms, higher fees can have an enormous impact on the final value of a portfolio.
The chart below shows £1 growing at 7% per year, with fee levels varying from having no fees deducted, up to a 3% annual fee:
After 40 years, the £1 could be worth £15 if no fees are taken, or under £5 if a 3% fee is charged. That’s a huge difference.
A 3% fee means a portfolio would only be worth one third of what it would have been had no fees been charged after 40 years. Obviously nobody can invest for free, and a 3% fee is on the high end of potential fees, so this is probably an extreme example. If we take a much more typical 2% annual fee which is probably more representative of what most investors are currently paying, this 2% fee halves the value of the end portfolio after 40 years.
Fees really do matter.
The problem with using percentages as a way to express the level of fees, is that it’s difficult to envision the actual cost in pounds and pence of a percentage-based fee. An innocuous 1-2% fee sounds small, but masks the massive impact it can have on a portfolio. Thinking about fees in monetary terms can help with contextualising how much an investor will be paying the various intermediaries involved in running the portfolio.
Below is a table showing how the value of £100 is affected by different fee levels over time (assuming no investment returns):
After 1 year, fees don’t matter that much. But the longer you pay fees for, their impact becomes exponentially larger. Paying 3% in fees reduces the £100 to just £30 over 40 years – a reduction of 70%. Even a relatively low 1% fee means the £100 is cut by a third to £67. Someone who pays 3% fees ends up with a pot worth under half what someone who pays 1% ends up with.
Another instructive way to think about fees can be seen if we think about what our portfolio could have grown to if only we’d paid lower fees. It’s staggering to see how much of our final portfolio ends up being paid out in fees after 40 years. If we take a fictional portfolio returning 7% a year, the graph below shows how much of the final portfolio value after 40 years would have been paid away with differing levels of fees:
A 1% fee means a 31% lower final portfolio value, a 2% fee means a 53% lower value, and a 3% fee means a 68% lower portfolio value. Whilst we used a 7% assumed return here, these percentages are similar no matter what the assumed returns are (+/- 2% for anywhere between 0% – 10% returns).
This clearly shows the devastating impact fees can have on a portfolio’s future value. They reduce the portfolio’s ability to compound by consistently siphoning off small amounts of the portfolio over a long period of time. This small, seemingly insignificant fee can have a massive impact on future wealth.
Who am I paying?
The more people that come between you and your investments, the more you’ll be paying. The more you pay, the higher the hurdle becomes for your investments to generate returns. It’s simple, but often overlooked.
If we start with an example, a typical way for someone to invest is via a financial adviser. While the adviser can advise on most areas of personal finance (and can add serious value when it comes to things like tax and estate planning), they rarely invest the money themselves. For this, they will appoint at least one external investment manager to manage the portfolio on their behalf, sometimes more. The investment manager(s) will then invest the cash accordingly, most usually in a selection of funds that they believe will outperform the market.
While this is a common way to invest, it also incurs high charges. The adviser will take a percentage cut of the portfolio for ongoing suitability, the investment manager will take a percentage to manage the money, and the funds that the investment manager invests in will take a percentage to invest in the underlying stocks/bonds. In this situation, there are three layers of intermediaries between the investor and the underlying stocks and bonds, with each of them taking a cut of the investor’s portfolio. It’s easy to see how these fees can all add up.
The charts below show a hypothetical example of how much of an investor’s expected return would actually be earned by the investor, after factoring in inflation and fees. The first chart shows the returns for an adventurous investor, expecting a relatively high return of 7%, and the second chart shows the returns for a more cautious investor, expecting a more modest 4% return:
In the examples above, the adventurous investor expecting 7% nominal returns per year before fees ends up with only 3% growth after inflation and fees. The cautious investor expecting 4% nominal returns per year before fees ends up not growing their wealth at all in real terms, after fees – their entire expected gain is consumed by fees and inflation.
Losing money is bad
Seriously, it is.
One of Warren Buffett’s most famous quotes is “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”.
Obviously this wasn’t meant to be taken completely seriously, otherwise we’d never invest at all. All investing carries risk and we’ll all incur losses at some point. But what he was more likely getting at was the disproportionately large impact losses have on a portfolio versus the gain required to recover from them. For example, a 50% loss on a portfolio requires a 100% gain to get back to even.
The easiest way to lose money on a portfolio is to give it away, and this is exactly what happens when we pay fees out of our investments.
These fees, as we’ve seen, quickly add up – but what people often don’t appreciate is the longer fees are left to compound in a portfolio, the higher the gain is required to offset their impact.
The chart below uses the same assumptions as above (7% return, 3% fees), and compares the reduction in portfolio value caused by fees to the subsequent gain required to offset their impact. Fees not only reduce the portfolio value (orange bars), but also increase the subsequent gain that would be required to break even (blue bars). After 40 years, the portfolio will have lost 68% of its potential value (as we’ve seen in the chart above), but the gain required to offset the effect of these fees would be 212% – a disproportionately large gain relative to the loss.
The gain required to offset the fees increases at a faster rate every year, as the impact of fees becomes larger and larger. This shows not only the impact of fees on a portfolio, but the immensely high hurdle that high-fee investment products need to overcome.
If we relate this to a real-world example, let’s use the same assumptions as above and say a global equity fund charges 3% a year. It must generate at least 3% more than global equity markets to avoid underperforming. If global equities return 7%, the fund must generate at least 10% a year before fees (7% + 3%). If the fund falls behind the benchmark and generates less than 10% a year before fees (less than 7% a year after fees), the compounding effect of underperformance quickly adds up. They need to add value over and above their benchmark by at least as much as the fees they charge, on a regular, ongoing basis. A string of underperforming years has an outsized impact on what the portfolio could have become, and becomes more and more difficult to recover from.
Why don’t people pay more attention to fees?
Secondly, and I think this is the main culprit, the fees charged by the underlying funds in a portfolio are deducted invisibly. The investor will never see the funds’ charges express in pounds and pence, as the fees are reflected as a reduction in the price of a fund rather than as a cash charge.
For example, a fund with a quarterly fee of 0.5% and a price of £100 will have the 50p fee deducted from the price of the fund – changing the price from £100 to £99.50. This is virtually impossible to notice on a portfolio valuation statement, and makes it very difficult to tell how much you’re actually paying.
For most investors investing through an intermediary, an estimation of the ongoing fees will be presented when the investor signs up for an IFA’s/investment manager’s services, which is expressed as a TER (Total Expense Ratio – sometimes known as an OCF (Ongoing Charges Figure)). This is, however, the only point at which the funds’ costs are usually discussed. Whilst both IFA and IM fees are usually disclosed on the cash statement of a quarterly valuation provided to the investor, the charges levied by the underlying funds are not. As a result, they’re usually quickly forgotten about. Given that TERs can range anywhere from 0.04% up to 2% and sometimes higher, they can form a large part of an investor’s fees, and because of their silent deduction from the fund price, can become a dangerously unnoticeable drag on performance.
If an investor decides to invest directly into funds without the use of an IFA or IM, it’s slightly easier to keep track of fund expenses. As all funds publish periodic factsheets (usually monthly), these can be used to keep track of a fund’s costs. It may be a somewhat manual task to keep track of each fund’s expense ratio, but it’ll at least give an investor an idea of the fees they’re paying. Investors will also need to be aware that investing directly into funds may incur subscription and redemption fees and FX fees that also need to be considered.
At the moment, the typical fee that a fund will report is the TER/OCF. However, in reality a fund charges investors more than just what is disclosed in their TER. In addition to the TER, a fund will also charge for both transaction costs (the costs of buying/selling stocks) and sometimes a performance fee (for outperforming a benchmark) – both of these are charged on top of the TER, but are not disclosed. In some cases the addition of the transaction costs and performance fee can add significant costs on top of the TER but, as they are not disclosed anywhere within fund literature, an investor would have to ask the fund house directly for a breakdown of these fees. At the time of writing (2018), a set of legislation known as MIFID II is in force, which requires funds and investment managers to disclose a better picture of what they are actually charging clients. However, the rules are not always being adhered to, which can lead to investors paying more in fees than they expect.
A third and final reason that fees can go by unnoticed is that, with so many intermediaries, it can be hard to keep track of all the fees being paid. Not only are fees paid to IFAs, investment managers, and fund managers, but in some cases there can even be a fourth layer – the investment consultant, whose job it is to advise on the performance and construction of the investment manager’s portfolio. Whilst consultants are more common for portfolios that are either held in trust or are especially large, needless to say, they need to be paid their fee as well. As there can be any number of intermediaries sponging off an investor’s portfolio, totting up all these costs and calculating their impact on a portfolio is beyond the scope of most investors. Intermediaries are understandably quite happy to benefit from the inertia and financial illiteracy of the average investor.
Are fees all that matter?
The fund universe is divided broadly into two types of fund. On the one hand, ‘active’ funds employ a fund manager and a team of analysts to try and beat the market. They charge higher fees, but aim to return more to the investor than they charge. On the other hand ‘passive’ funds simply try to track the index that the active funds are trying to beat – for example, a passive fund could track the FTSE 100, the S&P 500, or the MSCI World. In terms of fees, passive funds are usually much cheaper than active funds. Passive fund proponents would argue that trying to beat the market is a fool’s errand, and investor’s would be better off buying a cheap passive fund than trying to beat the market. For a comparison of the 2 approaches, please refer to the ‘Active vs Passive’ section of the blog.
While cost is an unarguable advantage for passive funds over active funds, regardless of whether active or passive funds are used, fees are obviously not the only thing to consider when choosing investments. Even when choosing passive funds, whose main attraction is their low cost, choosing the cheapest passive fund isn’t always the most sensible course of action. The list of other considerations is long, and can be highly subjective. For those interested in constructing their own portfolios, or understanding more about portfolio construction, I’ll be writing future posts on fund selection.
Conclusion
Despite not being a one-stop shop for selecting investments, fees are an incredibly important part of our portfolios, and play a large part in determining our ultimate returns. Understanding the role fees play in our investment returns is crucial, and we’ve looked at a number of ways to contextualise the level of fees paid:
- As an annual % of portfolio value
- In pounds and pence terms
- As a % of final portfolio value
- Versus the gain required to offset them
Also important is understanding who charges fees and how, particularly understanding how underlying funds charge their investors and how difficult it can be to understand the true cost of investing.
That brings us to the end of the series on factors that determine our investment returns. As we’ve seen throughout the last few posts, how much money you ultimately make through investments depends on your risk tolerance, how long you invest for, and how much you pay for it. Whilst your risk tolerance and time horizon are usually pre-determined (your risk tolerance is determined by your personality, and you cannot choose to invest for any longer), the fees you pay are always completely within your control. You have the ability to choose how much to pay for your investments, and given how much of an impact fees can have, that’s a powerful thing to be in your control.
Now we understand why we invest, and what determines our investment returns, the next post answers the question ‘Should I save or invest?‘.