Fund Costs Eat Away Returns
So why do costs matter? It's simple--they eat away at your returns year after year, and their impact compounds over time. Take a hypothetical fund that costs nothing, and earns 10% a year over 10 years. If you invest £10,000 initially, you'll have £25,940 at the end of year 10. Compare that to a fund that also returns 10% a year, with a total expense ratio of 1.70% per year. Investing £10,000 in that
offering will yield just £21,895 after 10 years. That's a difference of £4,045 over 10 years--an amount equivalent to more than 40% of your original investment, and more than 25% of the entire return of the no-cost fund.
The effect is magnified as the time period extends due to compounding. Let's reconsider the example above over a longer period. After 20 years, the £10,000 you invested in the no-cost fund would be worth £67,275--a tidy sum indeed. However, the fund that charges 1.70% per year would yield a final value of just £47,937. That's £19,338 less than the costless offering--a staggering amount equal to nearly double your original investment, and 33% of the total return of the costless fund.
Real World Proof That It Pays to Choose Low Cost Funds
Funds in the UK have not been required to disclose meaningful operating cost figures until recently, and to truly look at the impact of costs and capture the effect of compounding, you need to evaluate long periods of time. Our studies in the US market have evaluated 10 years of data and show that costs matter dramatically. Among US equity funds, for example, offerings in the cheapest quintile of their respective Morningstar U.S. peer groups were more than 2.5 times as likely to outperform their average peers over the next 10 years as offerings in their peer group's most expensive quartile. And that's for equity funds, where the cost effect is muted a bit by the volatility of returns. Among bond funds in the U.S. market, funds in the cheapest quintile of their peer groups were 6.9 times as likely to outperform their average peers as those funds in the most expensive quintile.
The relation between costs and success was no fluke--it held across all expense quintiles and major asset classes. That is, among US equity, international equity, and bond funds, the cheapest quintile was likelier to outperform not just the most expensive quintile, but each of the other three expense quintiles as well. The table below expresses the chances that the cheapest quintile of funds will outperform their respective peer group averages versus all other cost quintiles:
| Cheapest Quintile of Funds in: |
vs. Priciest Quintile |
vs. Second Priciest Quintile |
vs. Mid Quintile |
vs. Second Cheapest Quintile |
|---|---|---|---|---|
| U.S. Equity | 2.5x | 1.7x | 1.6x | 1.4x |
| International Equity | 2.2x | 2.2x | 1.7x | 1.3x |
| Taxable Bond | 6.9x | 3.2x | 2.3x | 1.5x |
| Muni Bond | 5.4x | 3.1x | 1.5x | 1.1x |
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| This table displays how investing in the cheapest quintile of US-sold funds within a given asset class would multiply your odds of success versus other cost quintiles. | ||||
AMC Is Not a Good Measure of Fund Costs: Look at the TER
Funds in the UK have only been required to disclose their TER for a little over a year now, and the requirement was instituted not by UK authorities, but by the EU's UCITS regime. Indeed, non-UCITS funds in the UK still don't have to report TERs. Prior to this change, funds reported only their annual management charge (AMC), also cites as annual charge, as if this was the only ongoing cost to investors. The problem is that in most cases, that's an utterly false assumption. It also creates patently misleading comparisons of fund costs. For example, Jupiter Emerging European Opportunities and Artemis UK Special Situations both carry AMCs of 1.50%. An investor looking at the two funds might well determine they have identical ongoing costs on this basis. Not true. The Jupiter fund has a total expense ratio of 1.96%, whilst the Artemis offering charges just 1.56%. That's an extremely large gap to be glossed over, but if you just look at the AMC, you wouldn't even know it existed.
Sadly, the only place the TER is currently required to be disclosed is the simplified prospectus. In other materials, funds are free to cite the AMC without reference to other costs. Thus, many fund companies in the UK continue to disclose only the AMC on their monthly fact sheets. And when firms announce new fund launches, they routinely cite only the AMC in their press releases. What's worse, they often describe it as the "annual charge", further creating the impression that the figure all inclusive. In our book, they should cite the whole cost, which is best represented by the TER measure. Otherwise, investors are quite simply being misled.
What Can Fund Investors Do?
So how can you protect yourself from high-cost funds? First, be sure you understand the costs of your investments, including any and all sales charges. Don't invest in any offering that doesn't disclose a TER. If the firm will only tell you the annual charge or AMC, walk away and find another offering. If you are using an advisor, make sure they tell you the TER of the fund's they have invested your money in. Second, don’t pay up. Yes, you might get lucky and find that great manager who can justify his cost. But over the long haul, the odds are stacked against you if you go with a higher cost fund. This is all the more true with bond funds, where the range of possible returns is much smaller, and the ability to add value more constrained.
Finally, consider buying trackers for the core of your portfolio. Less than half of UK All Companies funds have beaten the top performing FTSE All Share Index tracker over the five and ten-year periods, and less than 10% have beaten the top performing FTSE 250 fund over the same periods. When you use trackers, however, insist on using the lowest cost ones available. They have virtually identical portfolios, and there is no reason at all to pay more than you have to. For the All Share, Fidelity Moneybuilder UK Index is the low-cost leader with a TER of just 0.28% per year. For the FTSE 250, there is no good low-cost option in the traditional fund arena--HSBC FTSE 250 charges 0.89% per year, which is far too much for a tracker. You can cut that by more than half by using an ETF, however: iShares FTSE 250 charges just 0.40% per year. There's no reason to pay more.
