As many of my readers already know, the impact of fees on your investments is a critical determinant in how well your investment funds will perform.
Low cost funds are far more likely to exceed the in the hand returns of higher cost funds. The research comparing low cost to high cost funds is very clear on this matter.
Stuff media recently published an article that suggests costs are not so important after all.
There are several points made in the article which are all geared towards buying higher cost funds, like the ones provided by the articles contributor John Berry. No conflicts of interest there right? Their KiwiSaver fees range from 1.15% for conservative to 1.6% for the growth fund. This is very expensive when you can get a low cost index fund for a third of that cost.
Assuming a 25 year old earns $60,000 a year and contributes 3% a year to KiwiSaver, increasing each year with 2.5% inflation for 30 years, and earning returns of 5% in the hand, here is how two investors will look:
0.5% fees – $308,300
1.6% fees - $256,000
Over $52,000 in the lower fee fund assuming the same in the hand returns. How much will the active fund manager Pathfinder have to outperform the lower cost index fund by to beat the return of the lower cost product? Pathfinder fund would need 6.2% returns. A whole 1.2% percentage points better than the lower cost fund. Or put another way, an alpha of almost 25%.
How can Pathfinder guarantee their fund will perform almost 25% better than a lower cost equivalent? The answer is they can’t. Therein lies the problem. No one knows ahead of time which funds will perform the best.
With that being said, here are my issues with the article in question.
Lower cost does not mean lower quality in the investment fund industry
The research mentioned in the earlier link, clearly states that the majority of low cost passive funds exceed the long term performance of higher cost funds. Up to around 80% of funds in fact. Only 20% of higher cost funds beating the benchmark index over the long term. So the higher cost is not paying for superior performance or quality. The higher cost is actually paying for inferior quality in most instances.
As part of the quality dialogue, the article mentions that some KiwiSaver providers provide financial advisors free of charge. That is not a benefit, that is a cost. If a financial advisor is free of charge, then you are the product. You are selling yourself out to a biased and self interested party who has no intention to offer you the best advice for you if it doesn’t benefit them. No advisor from ANZ for example, is going to tell you you are better off with InvestNow.
Five years is not long term when investing
In the article they looked at 5 year returns and provided the headline statistic that the top actively managed growth fund outperformed the top passive growth fund by nearly 3% per year.
But if you dig deeper into the referenced report, you will see that there are 16 growth funds with 5 year returns. Only two of which are passive so is not a huge data set. The issue being that index funds are relatively new in New Zealand, in particular in the KiwiSaver space. Give it time and longer term returns for more passive index funds will start filtering through.
Only 4 actively managed funds beat the top performing passive fund, and 3 of them by less than 0.2 percentage points. There is a very good chance that their outperformance won’t continue as per the research on passive vs active funds. So 5th out of 16 funds over a 5 year period is not such a bad result for passive. Chances are passive funds will climb higher the longer the timeframe.
5 years is not a long enough period to judge results. Stock investing should be for a much longer period than that and consistent outperformance becomes much harder.
Out of the 4 funds that outperformed, how could someone have known which funds will be outperforming 5 years later? There’s a better chance an investor would have selected one of the 11 underperforming, higher fee funds. Do those active fund managers who charge higher fees refund your money for underperforming? Heck no.
It’s the after fee investment returns that matter
This is a statement regularly repeated by investment managers that charge higher fees in an effort to justify their higher fees.
The statement is actually true. But what they don’t want people doing is looking further into the research, because it shows that the after fee results are clearly in favour of lower cost funds.
Simple indexes beating approximately 90% of all actively managed U.S funds over 10 years plus. Many of these funds have hugely experienced analysts and staff trying their best to outperform the market like John Berry states in the article. But they are failing.
How to pick which active fund will outperform ahead of time?
It’s easy to look back in 10 years and say “look at this active fund that outperformed”. But what about all the active funds that underperformed the index? How will you know beforehand which small percentage of current funds will outperform the index in the next 10 years? Which ones will even still be around? WIll the winners from the last 10 years be the winners for the next 10 years (spoiler alert: unlikely)
Low costs are in your control. Externally managed fund performance not so much.
Final thoughts
So after fee returns do matter. And so does quality.
But don’t let any active fund manager convince you that lower cost equals inferior quality or lower in the hand returns. It simply doesn’t. In fact the reverse is true. Higher cost appears to be lower in quality if we look at results alone.
In many instances, lower cost does mean inferior quality. But not in the investment fund industry.
Most fund advisers make a living from your money so have a huge prerogative to keep the money train rolling. In addition, many active managers are rewarded for short term performance which is contrary to your personal long term timeframe. Even most advisors in the financial advisor industry have significant incentives to recommend certain funds to their clients. The talking up of higher cost funds will continue until more people wake up to the fact that low cost funds as a whole are providing more money in the hand to investors. The drum beat is getting louder and louder the longer index funds exist and active managers as a whole are having to get creative/disingenuous when it comes to selling their inferior products.
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The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here