Profit from paying lower fees on investments

This article appeared in the May 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Reducing portfolio costs can make a huge difference to long-term returns.

Photo of Robert da Silva By Robert da Silva, van Eyk

Fees are the "price" of an investment product. The total cost includes investment management fees, custodial fees, accounting fees, platform fees, administration fees, transaction costs, government charges and more.

Investment management fees are generally the largest part. Fees, added together and charged on a regular basis over the life of the investment, can make a visible difference to an investor's accumulated wealth.

That has driven many investors to simply buy the cheapest products, but this is not the best way to think and it typically does not deliver the optimal result. For a long-term investor, a more useful approach is to look for value for money in each investment product.

(Editor's note: to learn about the features, benefits and risks of low-cost Exchange Traded Products, take the free ASX online course.)

Understanding fees

Fees are like any other price in the economy. There are low prices for basic products, medium prices for added features and high prices for premium products. Most people manage their weekly budget (income) by buying various products across all these price points according to their needs, preferences and expectations. Value for money will be achieved if the product meets the expectations of the buyer.
When it comes to investing, the fees an investor pays should reflect their needs and expectations around risk and returns. These expectations will be influenced by certain beliefs about financial markets and investing. Examples include:

  • Active managers can outperform the market in the long run
  • Beating the market" is a mirage not worth pursuing, therefore matching the index is the best possible result
  • Early adoption of non-mainstream markets provides a performance advantage, for example, investing in "frontier" economies such as Indonesia, Nigeria or Turkey
  • Value beats growth
  • Small-cap stocks beat large caps
  • Environmental, social and corporate governance (ESG) principles are important
  • Clean energy and other "green" industries are the way of the future
  • Stock selection is more important than asset allocation, or vice versa.

An investor's beliefs and priorities, and the cost to produce certain products, will have an influence on the size of the resulting fee.

Generally, the following observations can be made about fees and how they relate to the type of product and/or their features.

Lower fee range Higher fee range
Diversified      Concentrated
Growth       Value
"Smokestack" traditional Clean energy/"green"
Pure return focus A focus on environment, social, governance issues
Low turnover  High turnover
Single asset class Multi-asset class
Index/passive Active
Exchange-traded funds Listed investment companies (although not always)
Mainstream markets Non-mainstream markets
Unleveraged     Leveraged
Simple       Complex
Large cap/core Small cap

Source: van Eyk

Fees versus outcome

Fees are what investors pay in expenses. The outcome is the resulting experience in terms of accumulated wealth, driven by net investment returns. The outcome is affected dramatically by the types of beliefs listed above and the investment choices made as a result.

Active versus passive is a key decision that can make a large difference to the end result.

(Editor's note: An active manager could manage a Listed Investment Company, for example, to achieve a higher return than the S&P/ ASX 200 index. A passive investment strategy could involve holding exchange-traded products to achieve the same return as the ASX 200 index.)

Active manager returns are not certain and will vary across managers, asset classes and investment styles. The competence and quality of managers is not universally consistent. Managers may outperform or underperform their benchmark index. Others may not take enough risk to generate returns meaningfully different from the index. These managers are often described as "benchmark huggers". That is, they charge active fees but deliver index-like returns, or often less than index returns once fees are subtracted.

van Eyk believes it is possible to identify superior active managers who can deliver "alpha"; that is, a higher return than the benchmark index (against which they compare their return).

Such managers provide significant benefits to long-term wealth outcomes relative to the fees they charge. Ineffective managers can have inconsistent or negative alpha (a return less than their benchmark index) and can damage wealth creation.

For investors who believe in active management, it is important to choose the right manager in the right asset class. These decisions are best made with research and guidance from experts.

An example of the impact of fees

The table below shows hypothetical outcomes from passive managers (A and B), who charge different fees for the same performance, and active managers (C, D and E), who charge the same (higher than passive) fee but have differing abilities to generate alpha (outperformance over a benchmark index):

Table 1: Passive versus active management

Manager A (passive) B (passive)  C (active) D (active)  E (active)
Years invested 10 10 10 10 10
Start value $100,000 $100,000 $100,000 $100,000 $100,000
Index return 7.50% 7.50% 7.50% 7.50% 7.50%
Outperformance 0.00% 0.00% 2.00% 0.00% -1.00%
Fee 0.15% 0.30% 0.90% 0.90% 0.90%
Net return 7.35% 7.20% 8.60% 6.60% 5.60%
End value $203,245 $200,423 $228,191 $189,484 $172,440

Source: van Eyk

Below is the loss or gain in accumulated wealth relative to these manager choices.

Passive fee difference (B minus A)

Loss of -$2,822 (7.20% return vs 7.35%) - due to higher fee for passive product.

Passive products tend to have less ability to differentiate since the outcome should be index performance. There are some features of value, such as the liquidity of large ETFs, otherwise fee-shopping tends to dominate (that is, investors choose the lowest-cost ETFs).

Benchmark-hugging active vs. cheapest passive (D minus A)

Loss of -$13,762 (6.60% return vs 7.35%) - due to higher active fee delivering passive returns.

Be wary of benchmark-hugging managers charging active base fees. In theory, higher base fees are associated with more active management of a fund, but this is not always the case. Indicators of "activeness" include higher turnover of stocks, a lower overall number of stockholdings and higher tracking error (the difference between the fund's return and the benchmark index).

If a manager does not have these active features and still charges significant fees, it is usually better to go with a truly active manager, a passive manager, or an index ETF, depending on the needs of the investor.

Premium active vs. cheapest passive (C minus A)

Gain of $24,946 (8.60% return vs 7.35%) - an effective active manager outperforming.

A premium active manager can add considerable value to long-term wealth, despite charging higher fees. This is where investors can get value for their fee dollar. Some sectors seem to have higher average alpha than others; for example, certain small-cap fund managers have outperformed their benchmark by over 10 per cent per annum for many years. This makes a huge difference over the long run and being fee-averse can carry heavy opportunity costs.

If Manager C in the table above had been a small-cap manager delivering 10 per cent alpha (10 per cent above their benchmark index) for 10 years while charging a 2 per cent fee, the outcome would have been $422,493 compared to $203,245 for passive Manager A, who had the cheapest fees.

Substandard active vs. cheapest passive (E minus A)

Loss of -$30,805 (5.60% return vs 7.35%) - a serial underperformer.

Active managers who do not have the skill set to consistently outperform while charging significant fees can do meaningful damage to wealth outcomes. The underperformance compounds with the higher fees to drag capital values down. It is clearly worthwhile avoiding such situations.

In general, large asset classes that are closely followed by legions of analysts and investment professionals provide less scope for active managers to outperform. For believers in active management, it may make sense to use cheaper passive products (such as ETFs and index funds) in some of these asset classes.

The fee savings can then be applied to potentially more rewarding areas such as small caps, value stocks, high-yield credit, absolute return funds or even leveraged funds where they are appropriate for the investor's profile.

The large, liquid sectors that fit the above description include:

  • Large cap/core domestic equities
  • Large cap/core international equities
  • Domestic sovereign bonds
  • International sovereign bonds.

Note that outperformance can be, and is, achieved in these sectors. It is just that if you must save money on fees, this is a reasonable place to start.

Performance fees

In its simplest form, a performance fee is a fee charged in addition to a base fee by the fund manager when a predetermined level of performance is exceeded, with the additional cost calculated as a percentage of the outperformance.

A "base plus performance" fee, when properly structured, can help align the interests of the manager with that of the investor. Below are some points to consider. One misaligned factor can dramatically disadvantage the end investor.

  • Performance fees should only reward a manager for outperforming an appropriate benchmark, after the base fee has been earned
  • Performance fees should be accompanied by low base fees
  • Performance fees should not apply until the performance exceeds its high watermark; that is, the previous peak in the value of the fund. This ensures that the manager must recover losses, or underperformance, before charging a performance fee.
  • Perpetual high watermarks are preferred. Some managers have the ability to reset their high watermarks, which effectively "forgives" the manager for previous underperformance. This is to be avoided.

What matters most in the long run is that net returns meet the investor's risk/return expectations. No matter the size of a manager's fees, if they are delivering consistently impressive net excess returns, they are likely to be value for money. Finding them is the hard part.

About the author

Robert da Silva is head of manager research and deputy chief investment officer at van Eyk Research.

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