05 Jan Costs Matter
The statement that investment costs matter should not come as a surprise to most investors. It is remarkable, though, just how relaxed some investors are about the costs associated with their investments. The problem has two root causes. The first is that in most walks of life, paying higher costs should help you to secure the best lawyer, architect or builder, yet when it comes to investing, this relationship can break down. The second is that costs of, say 1%pa do not sound very much, but unfortunately they are when compounded over time.
The majority of active managers, who promise to beat the market, fail to deliver on their promise. High costs are a contributory factor to this failure. Surprisingly to some, picking funds by their costs is one of the few useful metrics available to us. Research by Morningstar, a firm that makes a living providing star ratings for mutual funds, confirms this:
‘If there’s anything in the whole world of mutual funds that you can take to the bank, it is that expense ratios [i.e., ongoing charges figure or OCF] help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.’
A recent piece of research on US mutual funds reveals that the relentless drag of costs makes a meaningful difference to investor outcomes. It ranked equity funds, over 20 years to the end of 2021, into low and high-cost quartiles, of those with the lowest costs (0.84%pa) 31% were ‘winners’ (i.e. beat the benchmark) and of those with high costs (1.75%pa) only 6% were ‘winners’. Similar results were observed when funds were ranked by trading costs (incurred through buying and selling). In the UK, there is still a big gap between the ongoing charges figure (OCF) of active and passive (index) funds, and also reported trading costs, which recent research from Albion Strategic Consulting (2022) reveals. This is illustrated in the figure below, showing average fund costs.
Figure 1: Average active and passive (index) fund costs in the UK (end September 2022)
Source: Albion Strategic Consulting. Fund data from Morningstar Direct © All rights reserved.
If we construct a simple illustrative portfolio with 48% in global equities, 6% in emerging market equities, 6% in global property REITs and 40% in global short-dated bonds, the underlying fund level fees are 0.98%pa for the ‘high cost’ active fund version and 0.26%pa for the ‘low cost’ passive (index) fund version. With some straightforward maths, we can calculate the difference in wealth outcomes of investing in these two cost strategies over different time horizons.
For the purposes of this exercise, we will assume that the two strategies earn the same return, which is favourable to the active funds, as research shows that more than half deliver a return lower than the market1.
Figure 2: How much bigger your pot could be by using the lower cost strategy
Source: Albion Strategic Consulting
Investors who take the costs of their portfolio investments seriously and reduce these where possible should achieve a higher long term return all other things being equal.
John C. Bogle, the late founder of Vanguard and investment legend drew a powerful conclusion that investors should take note of.
‘The grim irony of investing 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.’
No wonder one of his favourite sayings and an approach we use at Bloomsbury when it comes to constructing portfolios is that ‘Costs matter!’
This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person. Your capital is at risk when investing. Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.
 Numerous studies including SPIVA® reports across several markets and time frames.
 Dimensional Fund Advisers: The Fund Landscape Report 2022
 This is provided for information and educational purposes. It does not constitute any form of advice. For illustrative purposes only.
 We use Professor William Sharpe’s return ratio = [(1-low cost %)/(1-high cost %)]^number of years.