Q: Why are fees so important when investing?

Kyle’s Answer:

With most things in life, you get what you pay for. If I buy a cheap pair of shoes I accept that they’re probably not going to last as long as a more expensive pair.

In investing, the same rule doesn’t apply.

This is because any fees you are charged reduce your return and as investing is a zero sum game (i.e. if someone outperforms the market someone must underperform), study after study has proven that professional investment managers struggle to beat the market after fees.

“But XYZ Active Share Fund has outperformed the market over the last 5 and 10 years and I saw the investment manager on TV and he seems to really know his sh!t?”

Fund managers will tell you past performance is no indicator of future performance. By extension, this also means past outperformance is no indicator of future outperformance.

I’ve looked at a 2010 research report from one of the biggest managed fund researchers in the market and in 2010 they gave eight Australian Large Cap funds their highest rating.

The research takes into account past performance, investment strategy, experience and ability, the stability of the team, as well as numerous other indicators.

Looking at these 8 funds now today (eight years later):

  • 3 no longer exist!
  • 4 have outperformed over the last 10 years with outperformance ranging from 0.63% to 1.9% per annum
  • 1 has underperformed over the last 10 years by 1.45% per annum

Remember the researchers who award these ratings to fund managers have experience picking the best investors and more time and resources to form a view. So if they can’t get it right, what hope do we have?

If we don’t have a crystal ball to predict which fund managers are going to outperform in the future, what can we do?

Control what we can control, that’s my first tip.

One thing we can control is the fees we pay to invest. Studies suggest the biggest factor affecting investing performance is fees. Low fees = better.

So how do low fees affect my investment outcome?

You’ve heard about compound interest and that even a small difference in returns can make a huge difference over the long-term when compounding works its magic, right?

As fees come directly out of the money you invest, it’s important to minimise fees to get a higher return.

Let’s say the market gives an after-tax return of 8% per annum over the next 30 years. If Index Fund A charges 0.2% in fees and Active Fund A (that struggles to outperform the index after fees) charges 0.8%, the respective after fee returns are 7.8% and 7.2%, respectively.

Let’s imagine you invest $20,000 now and add $6,000 every year for the next 30 years…

At the end of 30 years, the cheaper index fund will have a value of around $846,000 and the more expensive active fund will have a value of around $749,000. A massive difference of around $97,000! If we factor in inflation, that’s a difference of $46,000 in today’s dollars.

Put another way, that’s a pretty nice car or a few really nice holidays in retirement, just for being conscious of what you can control – your fees!

Kyle Frost is an independent financial adviser at Millennial Independent Advice (AFSL: 511 786), where he helps people in their 20’s and 30’s make smart decisions with their money. Click here to subscribe to his updates.