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Why traditional investing could be eating up almost half your returns

May 7th 2015

Imagine you were giving up nearly half of your investment returns to fees. Would you rethink your investment strategy?

Of course you would. But as dramatic as that sounds, it’s the reality for many investors. Forbes reported that a large number of investors are unknowingly giving up around 40% of their investment return to fees each year. And it’s those investors who take a traditional investment approach - buying active managed funds through a financial advisor - who are likely to be losing out.

This means looking at costs is an important part of selecting the right fund. And of course, there’s good news. There are more cost-efficient alternatives. But before we look at those, let’s see why cost has such a big effect.

Even an average total expense ratio is a huge investment headwind

The total expense ratio (TER) is the total annual cost of a fund to an investor. It includes other costs, such as trading and auditing, as well as the annual management charge.

Warren Buffett recently said that when he dies, he will recommend his widow puts 90% of her money into an S&P index tracker. Why? Because he believes returns will be superior to those of most investors, who tend to employ costly asset managers.

This insight is well supported. Over 75% of actively managed S&P funds underperform their benchmark over a five-year period. In its same report, Forbes gives evidence that most active managers fail to beat the market over the long-term.

And as Buffett says, using active managers is also costly. With a TER of between 1-2% a year, this is driving savvy investors towards cheaper vehicles. But while many use traditional index funds, they are still not the most cost effective option.

Morningstar’s Every Little Bit Helps research paper shows that exchange traded funds (ETFs) are cheaper still. While a retail equity index fund costs on average around 0.7% a year - significantly less than an active fund - this is still much more expensive than the average TER on an equity ETF, which comes in under 0.3%.

While the differences between these figures might seem insignificant, the effects of compounding mean they have a startling impact, as we’re about to see.

And then you add in advisor fees

For investors using a financial advisor, the impact of fees is higher still. Before the FCA’s retail distribution review, advisors’ portfolio management fees were usually wrapped up into a fund’s annual management charge. Nowadays though, fees are paid upfront.

On an investment of £200,000 (the minimum many advisors will even look at today), an investor will likely have to write a cheque for upwards of £2000 a year. Of course, this increases as an investment grows. And if the advisor is not doing much to actively manage the portfolio, then the fact that the investor now has to physically part with this money means they ask questions. And rightly so.

What’s the bottom line to you?

The long-term effect of paying even an average TER and advisor fee is eye-opening. Let’s look at what this means in numbers.

Taking an investment of £200,000, this graph compares the effect of fees in an ETFmatic portfolio to those of a traditional investor, over a 30 year period.

At a modest 7% return, a traditional investor would give up a staggering £573,809 in returns. Over time, those percentage points really start to mean something. What’s more, it puts marginal outperformance of a benchmark into perspective.

But does paying less mean foregoing portfolio management?

Of course, foregoing advisor fees means foregoing advice. So while it’s evident that the cost of investing should be one of your top considerations, what are the alternatives if you don’t have the time (or expertise) to rebalance your own portfolio?

The good news is that technology has seen highly efficient platforms come to market. ETFmatic, for example, provides investors with access to cost effective ETF funds. At the same time, its technology automatically rebalances a portfolio towards the right instruments that give an investor the best chance of achieving their financial goals.

Put simply, it’s a way to maximise investment opportunity while minimising the significant effects of costs associated with habitual ways of investing. With the combination of questionable active fund performance alongside the more transparent effects of costs, it’s little wonder that savvy investors are turning away from traditional investment approaches.

With all investments your capital is at risk and the value of your investments and the income deriving from it can rise as well as fall. Past performance is not a guide to future performance.