Guest post from Robin Powell of The Evidence-Based Investor blog...
Let's face it, we love to build on our wealth.
And through different outlets.
Gold, property and collectibles being a few examples.
And yet, when it comes to our pensions, one of the biggest financial investments...
We either don't know what we're paying for or don't seem to have a plan.
We often hear that the cost of investing is coming down, and in some cases it is.
But the total picture is actually less clear-cut.
Generally, around the world, the funds whose costs are falling are those that were already relatively cheap.
The cost of using more expensive funds has remained stubbornly high.
A research paper called The Mutual Fund Fee Puzzle shows that fee disparity in the fund industry actually "noticeably increased" over the 20 years.
This particular study focusses on US-domiciled funds.
But, there has also been a similar trend in other countries, including the UK.
So, what sort of disparity are we talking about?
Well, investors can buy a globally diversified index fund for, say, 25 basis points, or 0.25%.
A typical actively managed fund on the other hand comes with an annual charge of around 1%.
When you add transaction costs and other fees and charges, the final cost can easily come to 2 or 2.5%.
In other words, we’re talking about some funds costing up to ten times more than others, or a difference of 1000%.
Given the nature of compounding, the difference between paying 25 basis points and 250 over the course of, 40 or 50 years, can be astronomical.
The study even revealed that controlling characteristics like a fund’s style, size and risk level, has constant disparity in fund pricing over time.
Because of the compounding effect of fees, investors using more expensive funds were at risk of achieving substantially lower returns.
Interestingly, the researchers also found a wide disparity in costs among passively managed funds.
And even among funds tracking the same index — for example, the S&P 500.
To quote the paper:
“The costs for getting it wrong — investing in high-expense funds when close-to-identical low-expense funds are available — are large. We show that a low-expense fund investor could have earned 70% to 145% more (than someone who chose comparable funds at a higher price).”
So how do you explain disparity in fees and the fact that so many customers seem happy to pay for more expensive funds?
One explanation is that when you start a pension, retirement is so far off you’re not too concerned about the impact of fees and charges on an investment you might not need for another four or five decades.
Another explanation is that, over the last half a century or so, market returns have been pretty good; as long as the value of their portfolios were going up, investors have tended to not ask too many questions.
But how do the authors of The Mutual Fund Fee Puzzle explain the continuing disparity in fund fees?
There is a notion that a fund manager who commands a high level of trust may feel justified in charging more.
Another possibility is that they “do not capture relevant characteristics of the fund industry such as frictions accurately”.
Neither of these explanations can be completely ruled out, but “we also find it implausible to expect them to substantially reduce the large spreads in fees”.
Instead, they suggest, a more plausible explanation would be varying levels of sophistication and access to information among consumers.
Many retail investors, they point out, have limited knowledge of financial products.
“Thus,” the report says, “issues such as financial literacy.. should be of first order importance for regulators.. It is also important to increase transparency and comparability in the industry.”
The good news is that progress is being made on both fronts.
With the help of the Internet and social media, investors are becoming more savvy about investing and, particularly, the detrimental impact of costs on long-term net returns.
But total transparency won’t come overnight.
In the meantime, you can make sure to always know exactly how much you’re paying to invest.
And never assume that the figure commonly quoted is the total amount you’ll be paying.
Agreed, cost isn’t everything.
But it does make a huge difference.
And remember, the less you pay to invest, the more you get to keep yourself.