What's the biggest difference in the way professional investors invest their own money compared with non-professionals? It's fees. As professional investors we obsess about them. That's because we know that fees are the single most important hurdle for long-term returns.
Let's take a look at the effect of fees with a very simple example.
We invest £10,000 for a period of 30 years. Let's say the investment grows at 6% per year, a reasonable assumption given the historical growth of developed market share prices and earnings. In a simple world the beauty of compounding would kick in and after 30 years we would have just under £60,000.
To get access to markets you have to pay fees. Let's say you buy a FTSE Tracker fund and you pay 1% management fee. You also pay a 1.5% management fee on your investment platform. That means each year you lose 2.5% of your capital. How does your investment look now?
Instead of just under £60,000 you now have just under £30,000. Instead of the red line you earn the amount net of fees which is the orange line. Instead of earning 6% you paid away so much in fees that the return fell to 3.4%. Your return has halved!
The other problem is inflation. Cash buys less over time: a pound today will almost certainly buy less goods and less services in 30 years time. The Bank of England is actively steering inflation with a 2% target. So let's assume inflation is 2% on average. Now what happens to the real buying power of your investment?
Oh no! The investment in real terms that takes inflation into account has halved your return again. Now your return is just a paltry 1.4% on average over 30 years (the orange line).
This is why finance professionals obsess over fees and always shop around for products with the lowest fees.
If you want to play with the numbers yourself here's a spreadsheet you can copy and edit:
Fees Compound Too!
The reason why such an innocuous sounding fee like 2.5% can hurt so much is that fees, like return, compound over time. If you pay £1 in fees today that pound could have been earning you return for the next thirty years in our example. That's why fees affect return so much.
Let's recap in terms of what you get and what your fund manager and platform get:
- Total gain £47,434.91
- Lost in fees £30,053.24
- You get £27,381.67
Larry Bates, the founder of Wealthgame in Canada, has come up with a way to flag the disproportionate effect of fees over the long term. He calls it the Total Return Efficiency, or more memorably, the T-REX score. This is the proportion of the gain which you keep as a percentage of the total gain. In this case the T-REX score would be £27,381 / $47,435 or 58%.
Does it pay to shop around?
Yes!
For example here are two funds that track the FTSE AllShare Index which combines all the shares in the FTSE 100, FTSE 250 and FTSE Smallcap indices. Tracker funds have a simple job: if the FTSE AllShare goes up 1% so does the fund, if the FTSE AllShare goes down 1% so does the fund. Essentially they buy all the shares in the FTSE AllShare in the same proportions as the index, which for a big institutional investor is very cheap and very easy. Tracking shares should command a low fee.
The simplicity of a tracker makes it difficult to explain the variation in fees for FTSE AllShare trackers. Here are two extremes:
- Virgin FTSE All Share Tracker Fund: annual fee 1%
- iShares UK Equity Index Fund (UK) D Acc: annual fee 0.06%
This is a seventeen-fold difference in fee. Putting the numbers into our calculator spreadsheet for a 30 year investment (switching off inflation) this amounts to £14,800 in fees vs £1024 in fees. It pays to shop around.
What You Can Do About It
Here's a plan of action for minimising your fees:
- Learn about investing! A Power Hour with me would be a good start... If you know more you pay less.
- Find a cheap broker. Each purchase or sale of funds, shares and bonds will cost you broker fees. Pay as little as possible and shop around. Here's our list of the cheapest brokers in the UK.
- Shop around for cheap funds. The number to look at is the Total Expense Ratio. For example the fee for funds which passively track the FTSE 100 vary tenfold! Take a look at our guide on Finding Low-Fee Cross-Asset Exchange Traded Funds
- Consider cheap robo-funds If you don't have the time or the inclination to learn how to invest yourself there are off-the-shelf portfolios which are managed according to your risk preference and investment goals. Take a look at our guide Which Is the Cheapest Robo Advisor in the UK?
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