When you are weighing up investment choices, it’s tempting to go for the one with the highest return. But fees can be a real drag on the real rate of return.
Savvy shoppers often choose online bargains over boutique premiums. And smart travellers know that bottled water is cheaper from the local store than the hotel minibar.
We all make cost comparisons on a daily basis. Over time, these small decisions can add up to large savings. It’s no different when it comes to choosing who to invest your money with.
Whether you’re looking at investing in shares, managed funds, property or super, most investments come with fees attached. There may be transaction costs to buy and sell, and adviser fees and management expenses if the investment is professionally managed.
It’s important to remember that lower fees can have a positive impact on your investment return. Over 10 or 20 years, the difference between a high cost investment and a similarly performing low-cost alternative can be substantial.
Take managed funds, which are required to disclose fees as a percentage of your investment account balance, often called the management expense ratio, or MER. This fee is deducted from your investment balance each year.
Fees on Australian share funds tend to range between about 0.5 per cent and 2 per cent a year.[i]
So, for every $1,000 you invest, you will pay between $5 and $20 a year in fees.
A difference of $15 per year doesn’t sound like a lot, but it doesn’t stop there.
To use the analogy of homemade pizza, if you pinch away some of the dough before it has a chance to rise, your pizza will be smaller than it would have been if you left the dough untouched.
In the same way, the more fees that are pinched from your managed fund early on, the lower your investment base to rise in value over time.
Say you have $20,000 to invest in Australian shares and you’re choosing between two managed funds that are equal in all respects, except the fees they charge. For simplicity, let’s say both funds have a good track record and an earnings target of 8 per cent a year, which is close to the long-term average. Of course, past returns are no guarantee of future performance.
Fund A has total fees of 2 per cent a year, while Fund B has fees of 0.5 per cent. If you leave your money in Fund A for 10 years, your balance is expected to grow to $35,391 after deducting fees of $7,788. But if you choose Fund B, your balance is expected to grow to $41,085 over 10 years after deducting fees of $2,093.
In other words, you could expect to have an extra $5,694 in your pocket just by choosing the investment with the lower fee.
After 20 years, the difference is expected to blow out to $21,774!
You can work out the expected return on your real life investments using the Moneysmart managed funds fee calculator (moneysmart.gov.au).[ii]
Some people argue that ‘you get what you pay for’, and that paying more for the best investment managers will net a better result in time, but that is not always the case.
The proof, as they say, is in the pudding. When you compare investment returns, it’s important to look at the real expected return after deducting fees and other costs.
In our example, while both funds have a headline return of 8 per cent a year, the actual return from Fund A is only 6 per cent a year after fees. Expressed another way, that’s a 25 per cent drag on your return, year after year.
The actual return from Fund B is 7.5 per cent a year. While a 1.5 per cent difference in fees may not sound like a big deal, it can make a big difference in your buying power when you finally sell your investment 10 or 20 years down the track.
Some investment costs, such as tax and inflation, need to be recognised but there is little you can do about them. Similarly, you can’t control the market. Fees, on the other hand, you might be able to control if you are prepared to shop around.