Which is more important, fees or performance?
Performance rarely lasts, but small fee reductions can add materially to your retirement savings.
‘Nod continuously while pretending to take notes,’ comedian Sarah Cooper recommends as one of her 10 tricks to appear smart during meetings. Other tactics include occasionally chiming in with ‘Guys, guys, can we take a step back here?’ or asking the presenter ‘Will this scale?’ no matter what the topic is.
‘Will this scale’ is corporate mumbo-jumbo. But knowing how the cost of running a service changes relative to its popularity can tell you a lot about how a service provider treats its customers. We’ll come back to this idea of ‘scalability’ and how it relates to your investment performance in a moment.
After investing in a fund, just two things determine your return. The first is how the stocks within the fund perform while you’re invested, and the second is how much the fund manager charges in fees. That’s it.
Any manager telling you to focus exclusively on performance, however, should instantly pique your scepticism. They’re probably playing on something known as recency bias: our tendency to overemphasise recent events when considering what the future will look like. ‘Don’t stress over our 2% management fee,’ is the typical pitch, ‘our fund returned 15% last year.’
The antidote to this sales gimmick is to reflect on what statisticians call ‘performance persistence.’
Research by S&P Global looked at the performance of Australian actively managed funds between 2015 and 2020. Only 14% stayed in the top quartile three years in a row, and that figure fell to just 1% over five years.
Without turning this into a symphony of horn-tooting, we’re proud to say that over the past five years, the InvestSmart Conservative, Balanced and Growth portfolios beat 91%, 90%, and 87% of their peers respectively.
Still, fixating on performance – particularly short-term performance of 1–3 years – is likely to get you into trouble. There will always be periods – sometimes months, sometimes years – where returns disappoint.
Performance matters, fees matter more
Collectively, fund managers are too large to avoid buying the biggest stocks – they account for 61% of the invested capital on the ASX. If a fund owns, say, 40–100 large stocks, then the fund starts to look a lot like the market.
Fund managers are effectively buying and selling from each other, making one manager’s outperformance another manager’s underperformance. The average investor in those funds, then, will get close to the market’s average return – minus the fund manager’s fees.
Theory matches reality. We ran the numbers across 8,499 Australian funds for the five years to May: as a group, the funds underperformed their benchmarks by an average of 1.4%. Their fees averaged 1.6%. Given enough time, most fund managers will underperform the market by roughly the cost of their fees.
Management fees may seem trivial – typically ranging from around 0.5% to 2.0% a year – but over long periods they can take a huge bite out of your wealth. The magic of compounding works on costs too.
Let's say you have 30 years to invest $100,000 and will earn 8% a year over that time. Paying your fund manager 2.0% would leave you with $574,000 at the end of that period compared to $875,000 if the fee had only been 0.5% – that 1.5% difference at the start blew out to an extra 50% in retirement savings by the end.
Fund managers tend to come in one of two varieties: those who labour to charge you more fees, and those who strive to charge you less. We are fiercely the latter.
The fact is, nothing scales like money. A fund manager’s operating costs don’t grow at the same rate as funds under management. Running a billion-dollar fund doesn’t need 1,000 times as many employees as running a million-dollar fund. Costs are mostly fixed.
InvestSMART is a case in point: between March 2018 and March 2020, our funds under management doubled to $137m, but the business’s annual operating costs declined 8% during that time.
Fund managers who charge a percentage of what you invest become wildly profitable when funds under management grow faster than expenses. That’s why percentage-based fees are so seductive.
Nonetheless, last year we decided to cap our management fee at $451 a year no matter how much you invest. We’re the only Australian manager who does so. Our philosophy is that if our expenses aren’t ballooning, neither should yours.
When you can grow your investments without growing your costs, the results are dramatic. In our $100,000 for 30 years scenario above, a capped fee of $451 would lead to a final pot of $955,000 – an extra $381,000 worth of retirement cocktails compared to the 2.0% fee funds, and $80,000 more than even the 0.5% funds.
Our hunch is that putting more money in your pocket creates a sustainable future for our business too. Management fees never seem like a big deal in any one year, but they’re almost the only thing that matters over the long term.