Fees! Really?

Picture the scenario: You need to choose between two investment funds – a fund from Manager A and a fund from Manager B.

Historically over a five year period, Manager A outperformed Manager B by just 1% on a cumulative basis. 

Even relatively inexperienced investors would say that the difference is probably irrelevant, and they would say this for the following reasons:

1.     The two funds may have had different mandates

2.     The funds may have different benchmarks

3.     The funds may have different risk profiles

On top of this, we quite regularly see market movements of about 2% or 3% each day. So, a 1% cumulative performance difference over five years (~0,0005% each day) is largely immaterial and shouldn’t be the deciding factor when deciding on an investment. To put it in plain terms, if you invested R1 five years ago it would accumulate to a difference of just 1c.

This thinking is sound.

How we feel about fees

But what if we rephrase the scenario as follows: One of the managers charges annual fees of 1.0% pa and the other charges annual fees that are 20% higher (1.20% pa).

Surprisingly, all reasonable thought processes seem to become unnecessary and the important question of costs becomes central, often excluding everything else. We ignore fund mandates, benchmarks and risk profiles, and have a narrow-minded focus on a single fee number – that becomes the deciding factor. The cheaper manager wins, hands down.

The surprising thing is that at a glance, we can see that the two scenarios outlined above are the same. Yet our response is very different.

It’s an interesting thought experiment. We know we obviously can’t ignore all the differences between the managers, the benchmarks and the mandates, but we somehow justify that because we can’t really know how things will pan out in the future, at least we can choose a cheaper fund. We somehow pretend that everything else is like for like, even though we know this assumption has never been - and never will be - true. We overplay the importance of fees, even though we can see mathematically that it’s less important than we think.

Do funds with lower fees give better results?

Interestingly, the answer is no. 

An analysis of all the funds in the South African ASISA multi-asset, high-equity sector over the 10 years ending 31 December 2019 found that cheaper funds would have outperformed their expensive counterparts in most cases. However, doing this same 10-year analysis just one year earlier (ending 31 December 2018) found that the likelihood of top-quartile performance from cheaper funds was no better than the most expensive funds. In fact, over the period analysed, many funds that were more expensive were more likely to outperform (after all their fees).

At first glance, this may seem counter?intuitive. Yet, if one considers that when an asset manager’s performance is under pressure and they are losing assets, one of the strategies they employ to hold on to their assets is by cutting fees. Although not always the case, this could explain why cheaper funds may be the underperforming ones. 

Of course the issue of costs has some relevance. In the world of low growth, excessive fees make up a larger percentage of our overall return. Therefore, there must be some drive to minimise these. Fee pressure has in fact driven the rise in passive investing around the world with companies like BlackRock, Vanguard and others leading the way.

There is, however, an important condition: Fees from most managers in South Africa are at a competitive level. Further reductions are unlikely to add real value to the end consumer and would be swallowed up by most of the more important decisions that they need to make. One should always be sceptical of long-term projections showing a 2% or 3% difference in fees every year accumulating to a huge differential, always assuming everything else is equal. It would be difficult to ever produce a living scenario where this was true.

We need to focus on performance net of fees

In our current low-growth environment, what we need is alpha (outperformance). It is a far more important factor than fee cuts.  Although investing in a passive fund could be tempting, we know that 100% of passive funds underperform their benchmarks 100% of the time. So, investors looking for returns must be aware that this may not be the solution.

Instead, wisely choosing the right investment strategy, portfolio construction and manager has a much better chance of creating the alpha needed. Critically, we then need to align our investment behaviours with our long term goals – stay in the market, keep saving and then withdraw responsibly in retirement.

Clearly there is no place for excessive fees but it’s important to put fees into context. There are many investment decisions that are far more important than the 1c you may or may not be saving over five years.