In the investment world, it is essential to distinguish between what is knowable and what is not. The returns that you will make investing in the stock market, before fees and taxes, are unknowable. What you do know with certainty, is that your net returns will vary inversely to the amount of tax and fees that you pay.
Taxable investors should think about the amount of tax that they pay on their investments. All investors should focus on fees.
Many investors know that compounding investment returns, returns on returns, is the most powerful force in investing, particularly over the long run. What most do not realize, and what few investment advisers want to talk about, is that fees represent a form of negative compounding – compounding in reverse.
Despite the fact that the majority of professional investors underperform the stock market over time, most people still use them to invest their capital. Why? Largely because they expect to be in the minority that outperforms the market. Also, when dealing with a complicated subject such as investing, we are accustomed to obtaining advice from an expert. If this is the route that you choose, you should select an adviser who is competent, has an investment strategy appropriate for you and is trustworthy. You should also pay close attention to the fees that they charge.
Clients pay different types of fees. The largest component is the management fee – paid directly to your adviser and/or to the manager of the product you purchase (such as a mutual fund). The average fee that you pay will have a dramatic impact on your investment returns and your ability to build capital. As much as it pains me, as a member of the wealth management industry, to highlight it, management fees are often too high.
Management fees are also more expensive than they first appear. This is because of the opportunity cost that they represent – every dollar paid is one dollar less that can compound positive returns for you. Thus, the impact on your returns is higher than the fee itself.
The table below demonstrates the impact of fees on an investor buying a low-fee (0.1 per cent) ETF compared with a mutual fund that charges 2 per cent, which is less than many charge. The table assumes that both the ETF and the mutual fund have achieved returns equal to the S&P/TSX Composite Index over the past 20 years. As can be seen, a 2-per-cent fee would have reduced an investor's cumulative return from 88 per cent to 56 per cent over the first 10 years and from 209 per cent to 112 per cent over the full 20 years. In addition, one can see that the overall cost to the investor is materially higher than the fees paid.
Some investment managers also charge performance fees. These are incremental fees paid on top of a base fee when the manager performs better than a chosen benchmark. Those that charge them argue that performance fees better align them with the client by providing more incentive to perform, and that the client only pays in the event of outperformance (win-win).
However, performance fees are usually a one-way street – managers take them in good years, but don't refund them to you in bad years. Given that, in most calendar years, stock markets either rise by more than 20 per cent or produce a negative return, performance fees can badly whipsaw clients.
Among investment firms, it is hedge funds that most commonly charge performance fees. Like other investment managers, most hedge funds underperform the broader market. This is highlighted by a bet Warren Buffett made in 2008. He challenged several hedge fund managers to pick a group of hedge funds that would outperform a low-fee index fund tracking the U.S. stock market (S&P 500 Index) over 10 years. By the end of 2013, the cumulative return of the index fund was 44 per cent, while the group of selected hedge funds, picked by industry experts, had returned only 13 per cent.
Today, stock markets appear fully valued and fixed-income yields are at historic lows. More than ever, the proper management of your investments is important. Some investment managers charge reasonable fees and some do not. Some will be worth the fees that they charge and others will not.