Above a certain size fund managers can only invest in the biggest of stocks. They need to be able to purchase a large enough stake without pushing the price up and sell out without inducing a crash. And the need to diversify means their portfolios quickly start to look and perform like the overall index they’re measured against. By definition, your returns will be average because the fund in which you invest is a proxy for the average.
There’s one big difference between an average market return in the abstract and receiving it through a managed fund: you pay a fee for it. This uncomfortable truth is one reason for the boom in roboadvice and exchange traded funds. If you’re happy with average returns – and many investors are – then make sure you get them at a low cost.
A fee of, say, 1.5% of assets under management may not sound like much, especially set against historical returns. Fidelity estimates that over the 30 years to 31 December 2015, Australian shares returned 10.2% per annum. But that 1.5% fee to capture the average return is 15% of the growth in your investment.
Sleight of hand
The industry relies on this numerical sleight of hand to make fees seem smaller than they really are. And this trick is about to become even more costly. It’s a great mistake to think that the future will automatically look like the past and yet that’s what many investors are implicitly assuming.
The yield on 10-year Australian bonds is just over 2%. If the market’s best guess about the future risk-free return is 2%, the average annual return for equities will probably be more like 7% than the 10% we’ve experienced over the past few decades.
What happens to fund management fees in this scenario?
If you’re paying a 1.5% fee for a 7% return, then the percentage paid in fees rises from 15% under the old scenario to over 21% (more than a 40% increase). Yes, more than a fifth of your return will be given away for what is likely to be average performance.
That’s what happens when your expected annual return falls.
To vamp things up a little – in the way that funds managers like to dumb them down – your fee as a percentage of the growth delivered has just risen by almost half, for a lower absolute level of performance.
The takeaway? If you’re investing in index funds or funds that behave like them but aren’t labelled as such, you should always try and minimise fees. If you haven’t already done so, the argument to act now is more than twice as powerful. Get compounding to work for you, not your overpriced fund manager.