Why costs are the most powerful predictor of returns

There’s plenty for investors to worry about. Inflation has hit a 40-year high, national and corporate debt is about as high as it’s ever been, and it’s far from clear that central bankers will be able to tame inflation without spurring recessions. Few people expect overall investment returns to be as strong in the coming decade as they were in the past one.  

More encouragingly, if Investors' Chronicle columnist Mr Bearbull's view is correct ('Inflated fears' IC, 10.06.22), in the long run inflation has little impact on the performance of equities. It’s also a factor that we can neither predict nor control.

Similarly, you could spend weeks studying the processes of different fund managers to try to determine who might have an edge. But much of the reason for who or what succeeds will in the end come down to luck or, at least in part, circumstances that could not have been foreseen. 

The one thing we do have significant control over, however, is how much we pay for our investments. And keeping costs low could be the single biggest predictor of your future returns because of the compounding effect of fees. While a fee difference of 1 per cent might not sound like much, the long-term impact can be spectacular. 

To illustrate this, the chart shows the performance of an initial investment of £100,000 with returns based on the performance of the MSCI World Index over the past two decades. The orange line shows how much money you would make if your annual costs were 0.3 per cent, the dark blue line if your annual costs were 1.3 per cent and the yellow line if your annual costs were 2.3 per cent. 

I have chosen these levels of charges because 0.3 per cent is close to the lowest ‘total cost of investing’ you could hope to achieve if you invest in a tracker fund via the Vanguard platform. The total cost of investing includes ongoing fund costs, transaction charges and the platform fee. 1.3 per cent might be a reasonable estimate of the average ‘total cost of investing’ in an active fund on one of the big platforms, although both active fund and platform fees vary hugely. For example, the biggest fund on the biggest platform – Fundsmith Equity (GB00B41YBW71) on Hargreaves Lansdown – has an annual average charge of 1.41 per cent. Many funds are significantly more expensive, particularly if they have performance fees or invest in alternative assets, so I have included the 2.3 per cent figure to reflect these. 

In this example, £100,000 invested in global equities two decades ago would be worth £275,640 today if you put it into an investment with an annual cost of 0.3 per cent. For costs of 1.3 per cent the return falls to £225,310 – a total return reduction of 18 per cent. And if £100,000 was invested in a fund with costs of 2.3 per cent the total return would be a third lower than for one with costs of 0.3 per cent. If you continued to add money to the account every year, the difference between the two lines would be even more striking.

“Another thing to consider is fees not relative to assets, but relative to growth,” says Henry Cobbe, head of research at Elston Consulting. “If expected returns are 5 per cent and fees are 1 per cent, that means 20 per cent of growth is paid in fees. If expected returns are 5 per cent and fees are 2 per cent, that means 40 per cent of growth is paid in fees.”

Check the charges

If higher fees come with higher performance, they might be worth paying. Performance on fund factsheets is shown net of the fund managers' charges. However, fund management is rarely 'reassuringly expensive'. 

“Normally when you buy something, the more you pay the better the product or service is,” says Robin Powell, editor at The Evidence-Based Investor. “But with investing it works the other way around. Generally speaking, the less you pay to invest, the higher the net returns you can expect to receive.”

A study by fund research company Morningstar a few years ago looked at the variables which predicted the failure or success of a mutual fund and found that cost was the factor with the highest predictive power. Looking across every asset class, Morningstar found that the cheapest 20 per cent of funds were three times as likely to succeed as the most expensive 20 per cent of funds. 

“Costs are simply a return that needs to be overcome to break even,” says James Norton, senior financial adviser at Vanguard. “The higher the cost, the higher the hurdle.”

Or, to put it another way, compound interest is one of the most powerful drivers of wealth creation but fund fees can eat away at this advantage if you’re not careful. 

The range of fees

There’s a big range of fees you need to take into account. When looking at funds, Cobbe says there are three levels to look at. 

The annual management charge (AMC) is how much the fund manager receives. The ongoing charges figure (OCF) includes the AMC and represents the all-in costs of the fund, excluding transaction costs. The portfolio transaction costs represent all in charges and should be shown in any costs and charges disclosure, but generally the OCF is more prominent. 

“OCFs are easy to find [but] portfolio transaction costs are hard to find,” says Cobbe. “Good platforms show them but may call them something different. That’s why most people just focus on the OCF”.

You normally also have to pay platform custody fees and sometimes dealing fees. Many platforms don't charge for trading funds, or charge significantly less for fund trades than listed securities trades. Some platforms, such as iWeb and interactive investor, charge a fixed fee across all accounts while others charge a percentage of assets, and several large platforms cap the fee for listed securities. 

Our recent Isa platform charges and Sipp platform charges round-ups set out the fees of several platforms in greater detail ('How to pick the best platform for your Isa' IC, 11.03.22 and 'Picking a low-cost Sipp provider' IC, 27.05.22). With pensions, also check the drawdown charges and, if relevant, transfer charges.

Transaction fees might be the most overlooked type of charge. Many platforms offer commission-free trading, but even if you aren’t paying commission to your broker there is a bid-offer spread when you buy or sell listed securities. “So there’s no such thing as free trading,” says Powell.  

And securities with low liquidity tend to have wider spreads. “Investors should be wary of buying illiquid holdings with large spreads as these may not add real value to a portfolio but could introduce additional risk,” says Norton. 

However, most funds have a single price and spreads on exchange traded funds are typically very narrow.

So have a look at how much you are paying in investment fees, and think about how much you might save by switching to a cheaper platform or investment.