Why You Should Care About Investment Fees
Updated: Jan 13, 2021
As an armchair investor who only really knows what he's learned about investing from reading the internet and the hard lessons we all go through when we start investing, (I'll never forget the Dragon Oil "Hot Tip" I got when I was in my first job. I put a months wages on it only to sell at a loss 3 years later) it would be a lie to say I know what I'm doing. However, what I have learned on that journey is that nobody has a crystal ball and no one can predict what the economy, stock market or weather is going to do 5 years from now.
There are some "known known's" that can be scientifically proven though:
Over time the stock market as a whole always has always gone up, the amount of time is the only variable.
History has proven that the stock market outperforms any other kind of investment over the long term including property (although only marginally)
The historic return of the S&P 500 index has been 10% since it began almost 100 years ago despite fairly regular stock market crashes (8 major crashes over that period).
You'll never meet a poor investment banker
I'm sure there is a myriad of challenge that could be given to those statements so if you feel strongly, have at it in the comments section but you can't argue that they are generally true.
Further to this, in our always on, internet connected, disruptive Fintech world, you can pretty much invest your money in most things globally at almost zero cost. For example, I'm British, living in South Africa and I like to invest in the S&P500 Index in the US and I can do that through an app at a cost of $1 every time I want to buy or sell at the touch of a button 24 hours per day.
The particular fund I mostly invest in; The Vanguard S&P500 ETF (Ticker: VOO) has an annual fee of 0.04% per year, so assuming you invest R1,000,000 / $55,555 / £45,454 into it, your yearly fee is hardly going to register at R400 / $22 / £18 when on average it has paid a 13% return each year since it's inception 10 years ago (and yes, that includes the current stock market crash). So using that method and assuming I buy monthly, I have total costs for the year of $12 for 12 buy transactions and $22 in fees. $36 total costs. My return for the year would be $7,222, a net profit of $7,186 / R129,350 / £5,879. I think those fees are more than fair for managing the paperwork for me so all I have to do is hit a button once a month!
So then, why do so many of us choose investments with fees of 1, 2 or even 3%? Simple answer, greed, naivety or laziness. Mostly all 3.
You've read the warning on just about every piece of paper with investment information on it right?
"The value of investments can go up or down and you may not receive as much money back than you invested. The past performance of investments is not an indicator of future performance"
Or something along those lines. If you've ever invested or even looked at a financial advertisement, you've seen that, you many have ignored it, but you've seen it. There's a reason it exists, because no one can predict accurately what the market is going to do in the short term.
So if we go back to the basics that the stock market goes up, and no one (no one at all) can predict the future, why would we believe that someone could consistently outperform the market as an average? That's exactly what we're doing when we invest in an actively managed fund which is bench marked against an index. You know, the ones that we have all invested in at some time, the ones that charge up to 3% fees.
Because we're greedy and we want more than the 10% the market has averaged for 100 years, or because a "friend" told us about a sure thing, or we believe that Hydrogen powered trucks are the future so any company producing them will make us rich if we get in early, or we trusted a financial adviser to give us the best product at the moment and he must know something we don't. Right? Wrong.
So for the purposes of this debate lets add to the list of "facts" that fees are questionable in their value, certainly fees above say 1%. Now let me try and convince you that statement is true.
You take out a simple investment like an actively managed fund that invests in the stock market with a target to grow your money by say 8% every year until you cash it in. You're 25 and you'd like to invest for 30 years. For simplicity, lets say you invest $500 per month for the full term (for simplicity, we'll ignore inflation in this example). The investment company charge you a fee of 1.5%.
At 8% return, you should end up with a nest egg of $734,075 when you hit 55. Schweet!
This is a pretty realistic scenario today, lets take a look at the impact of those fees.
For year 1 you've paid in $6,000 and paid fees of $90, the market is flat this year . Not a great start but that's a big correction out of the way so should be gravy from here. Notice, the investment manager still took his full fee despite delivering under-performance. Cheeky! so $11,910 goes into the investment in year 2
The fund returns 8% in year 2 and that means at the end of the year, your pot grows to $12,862, not bad. y fees of $193
Year 3, and $18,669 goes back into the market. This year the market returns 10% and you end the year with $20,535. The company take their cut of $308. You forgive the investment manager for year 1.
$26,227 goes into the market. year 4 is another good year with a 9% return and you close out with $28,587, it's going pretty well. You pay your fee of $429 and $34,158 goes back into the market ready for year 5. You send the investment manager a bottle of wine at Christmas and you tell everyone you know that they should invest in your fund as you're outperforming the market.
You get the idea, the process continues for 30 years, the stock market averages 10% return (which it was going to do anyway) and by "Pure coincidence" so does your fund. You close out your investment with a pot of $785,442. You go back to your original agreement which was an 8% return and a pot target of $734, 075. You've made an extra $51,367 more than plan, That's an extra 7%, you're one of life's winners and an investing genius, you plan to spend the extra $50k on that Porsche Boxster you've always wanted to display your wealth and investing prowess. Go you!
But, (you knew there was going to be a but) the facts of this feat in today's society are:
You would have paid the fees even if the investment hadn't performed, all the risk was on you
The stock market returned an average of 10% over the period anyway so where was the value of "Active Management"
Whilst there were years where it appeared you'd beaten the market, as the years rolled by, the average return aligned to the index almost exactly.
And here is the kicker, if you had picked a low cost index fund like the one I described above (but there are plenty similar) and paid fees around 0.2% (easily achievable ), and enjoyed the same stock market performance of 10% annual return, your investment would have returned $1,039,356.
Yes, I did say over a million bucks.
$1,039,356 vs. $785,442 - That's $253,914 you lost due to what appears to be a "reasonable" admin fee of 1.5%
Yes, I did just tell you that that 1.5% investment fee cost you more than a quarter of a million dollars.
Let me just twist that whilst it's in there, your profit using an actively managed fund was $605,442. If you had bought a cheap index fund and set-up a monthly automatic payment into it of $500 a month (about 3 hours work max) and done nothing else for 30 years, you would have profited $859,356. That's 42% more profit.
So after that climactic conclusion, let's summarise.
If you believe the following:
The stock market will average 10% return over a period of at least 10 years (but the longer the better)
That no one can guess what is going to happen to the world or financial markets accurately in the next 10 years or beyond
That you have the discipline to not to touch the investment for at least 10 years or more
That the Index you invest in will still exist in 10 years e.g. the S&P500 which is 100 years old so far
And you do the following
You buy a low cost index tracker
You invest a lump sum or regular contribution to it and other than that leave it alone until your target date.
Then I truly believe
You will do the same as or better than any actively managed fund which is bench marked against the same index.
You will make significantly more money by not paying fees to a fund manager.
Now it's impossible to say if I'm right and no one should take this as investment advice, this is my opinion and only you can decide but I'm not the only one with this view, in fact it is one of the cornerstones and broadly accepted belief of the Financial Independence community (FIRE)
I'm also not bashing investment companies or fund managers, I'm sure some of them are perfectly nice people who understand the markets in a way I don't, but they are not bloody clairvoyant or they wouldn't need a job would they?
Even one of the most successful investors of all time Warren Buffet agrees with this and he has a net worth of around $70,000,000,000 (70 billion!) made primarily from the stock market. He has even announced several times that when he passes away, his estate will be invested 10% in cash and 90% in a low cost S&P500 index tracker for his surviving family.
At the end of the day, you do you, but if you do one thing this week, look at every investment you've got from mortgage to pension to savings and find out what fees you're paying on them, as you can see from our example above, just 1.3% in fees (1.5% vs. 0.2%) ended up costing our investor 42% of his return over the life of his investment.
And that's why you never meet a poor investment banker