Costs matter - make sure you know exactly what you’re paying to invest

Costs matter - make sure you know exactly what you’re paying to invest

“Price is what you pay.  Value is what you get.”

Warren Buffett

Costs matter.  Regardless of what it is you are buying, the costs that you expect to pay are likely to be an important factor in deciding to purchase.

You wouldn’t think of buying a car – or making any other large purchase – without knowing what you were going to pay.  We recognise when we are sat in front of the car salesperson that the basic price with which they start is going to go up once we consider the extras we’re going to want to add but we still know exactly how much we’re going to pay before we sign on the dotted line.

Of course, there’s more to it than the purchase price of the car.  You need to consider the running costs once you’ve bought it.  You may not be able to calculate these precisely, but it’s not as if the DVLA sends you a bill for car tax each year for an amount that you had no clue you would be paying.  Neither does your insurer.  You don’t fill up with fuel without knowing how much each litre will cost you and many a dinner party has been ruined by the bore who goes on and on about how many miles they get to the gallon.

We rely on a lot of different information about costs to help inform our purchasing decisions.  Some costs are easily determined while others can require a bit more digging to unearth.  The same applies when investing in funds – there are a number of different ‘layers’ of costs which you need to consider.

ONGOING CHARGES FIGURE (OCF) – ‘THE LIST PRICE’

The OCF can be thought of in the same terms as the ‘list price’ for a new car.  It was introduced in 2012 and replaced the previous figure known as the ‘Total Expense Ratio’ (TER). 

Exhibit 1 helps illustrate why the charges you incur are so important and shows how higher charges can impact performance.  The data is US-centric but the same principles apply for UK investors.

This data shows that funds available to US investors with higher average charges had lower rates of outperformance.  For the 15-year period to 31st December 2016, only 9% of the highest cost equity funds outperformed their benchmarks.  This data indicates that a high expense ratio is often a challenging hurdle for funds to overcome, especially over longer horizons.  From the investor’s point of view, an expense ratio of 0.25% vs. 0.75% means savings of £5,000 per year on a £1 million account.

As Exhibit 2 helps to illustrate, those pounds can really add up over longer periods.

Exhibit 1 High costs can reduce performance: US equity mutual fund winners and losers based on expense ratios (%)

The sample includes funds at the beginning of the 15-year period ending December 31, 2016. Funds are sorted into quartiles within their category based on average expense ratio over the sample period.  The chart shows the percentage of winner and loser funds by expense ratio quartile; winners are funds that survived and outperformed their respective Morningstar category benchmark, and losers are funds that either did not survive or did not outperform their respective Morningstar category benchmark.  US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago.  Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Small Blend, Small Growth, Small Value, and World Stock.  For additional information regarding the Morningstar historical categories, please see “The Morningstar Category Classifications” at morningstardirect.morningstar.com/clientcomm/Morningstar_Categories_US_April_2016.pdf. Index funds and fund-of-funds are excluded from the sample.  The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations.

Source: Dimensional Fund Advisors, ‘The 2017 Mutual Fund Landscape’. Past performance is no guarantee of future results.

Exhibit 2 Hypothetical growth of £1 million at 6%, less expenses

For illustrative purposes only and not representative of an actual investment.   This hypothetical illustration is intended to show the potential impact of higher expense ratios and does not represent any investor’s actual experience. Assumes a starting account balance of £1,000,000 and a 6% compound annual growth rate less expense ratios of 0.25% and 0.75% applied over a 15-year time horizon.  Taxes and other potential costs are not reflected.  Actual results may vary significantly.  Changing the assumptions would result in different outcomes.  For example, the savings and difference between the ending account balances would be lower if the starting investment amount was lower.  Source: Dimensional Fund Advisors

THE ‘ADD ONS’ AND ‘RUNNING COSTS’

Sadly, neither the OCF nor its predecessor live up to their names and represent the full range of all costs paid by investors, as neither include dealing costs.  These can be quite substantial in a fund with a high level of turnover (i.e. where the fund manager trades frequently within the fund).  A study by the Financial Services Authority (FSA) – now the Financial Conduct Authority (FCA) – in 2000 estimated that a fund with 100% turnover would add in the region of 1.8% per annum to the costs of owning the fund.

Thankfully, charges have generally reduced since then, but in its most recent report, published earlier this year, the FCA still found a lack of transparency surrounding the total costs investors pay, and called on the investment management industry to move towards a greater transparency of the total cost of ownership.

You might think 100% turnover sounds high, but in practice it isn’t.  From a study carried out in 2006 (Lipper Fitzrovia (2006), Benchmarking UK portfolio turnover 4th edition, Lipper) we know that at that time, the turnover for the median (i.e. half were lower and half were higher) UK-based equity fund was around 59% using the SEC calculation basis (which disregards transactions due to inflows and outflows – when the manager is obliged to trade – so that it only reflects those which result from voluntary ones).

Index-tracking funds, in which transactions tend to be less frequent than for actively managed ones, typically have a turnover of around 20%.

So, while the OCF is an important piece of information for you to know, what matters most when gauging the true cost of investing is the “total cost of ownership”.  As with car ownership, where the list price is often just the starting point, the total cost of ownership is more than just that headline OCF figure.  It includes not just costs that are relatively easy to determine as the information is readily available, such as the OCF, but also those that are more difficult to assess, like trading costs and portfolio turnover – data which is less widely available to the non-professional.

Continuing our car analogy, the impact of trading costs is like driving your car as if you were an F1 driver – accelerating quickly, driving at very high speeds, and then braking hard at the last possible moment.
By kidding yourself that you’re the next Lewis Hamilton, the more wear and tear your car is likely to experience, the more fuel you will end up using and the more the total cost of ownership will increase. And even Lewis Hamilton crashes sometimes or has his car break down.

CONCLUSION – DO YOUR HOMEWORK

The moral of this piece is simple.  Employing funds within your portfolio which embrace the strategy of keeping turnover low, remaining flexible and transacting only when the potential benefits of a trade outweigh the costs can help keep overall trading costs down and help reduce the total cost of ownership.  And remember, every pound you don’t pay in costs is a pound extra in your pocket.

The total cost of ownership of a fund can be difficult to assess and requires a thorough understanding of costs beyond what an expense ratio can tell investors on its own.  So, do your research.  A good place to start would be here.

I’ll leave the last word to perhaps the greatest exponent of low costs:

“First, in investing, realize that you get what you don’t pay for.  Whatever future returns the markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns, simply because of the high costs of investing — all those commissions, management fees, investment expenses, yes, even taxes — so pare them to the bone.”

Jack (John) Bogle, Founder of Vanguard

Warm regards

Carolyn