How to cut investment costs – and what bits to keep

Investors might be surprised at how big an impact expenses can have in the long term, and how much is still hidden. Yet there are ways to cut costs, as well as some apparent savings that are likely to be a false economy. “Do costs matter?” might look a simple question, but is often confused with issues such as whether stockmarkets go up over time, the value of an investment adviser, or if active fund managers perform. Investment management is a complex service with uncertain outcomes, making it easy for expenses to get lost in the noise. But, regulators around the world now think that investors should have a better understanding of what they pay, as well as performance.

Studies suggest that average expenses can be typically around 1% per year of an actively managed portfolio. This includes fund management, administration and some regulatory costs. Trading costs and other consequences of investor behaviour can add as much again. This includes the unwitting impact of trying to time investment in and out of markets, or rotating between sectors or asset classes. These costs might not seem much, but future investment returns are likely to be lower in an environment of subdued global growth and low yields. And, inflation and tax can also impinge on gains. Even 1% compounded over a lifetime of saving, can make a dramatic difference to wealth in retirement. Getting value for money is what matters. That might be better investment performance, risk reduction, or tailoring of a strategy to an individual’s own goals and preferences.

Of course, picking the right investments matters, too. In theory, good managers should deliver more for their money, and they market their skill as an edge worth paying for. The challenge for investors is keeping all those costs under control with the best balance between shares or unit trusts, bonds and cash. Getting the mix right can minimise the penalty of a forced sale at market low points, or can lower average portfolio running costs and tax. The skill of an investment adviser or wealth manager can be worth it, to get this overall structure right.

It is easy to see why costs are confusing. Performance fees for managers might look a good idea to align incentives and bring down base fees. But it means that a portion of future management expense cannot be known in advance. And, whether the performance incentive itself is well designed, is complex. And dealing commissions will depend not only on what terms an investment manager has arranged with stockbrokers, but how much activity takes place in the portfolio. This can vary markedly from year to year. It is also an uninvoiced cost that may need a bit of homework by the average investor to pin down.

Research has suggested that investment management skill is improving over the years, but also that this potential benefit is lost as funds grow big. The growth of the industry, and of some well-known funds, has tended to dent performance. Regulation has encouraged this trend, but the apparent safety of large funds may mean fading performance. This is the area in which a wealth manager may be able to help individual investors by identifying some lower cost passive vehicles, such as index funds or similar exchange traded funds. These can increasingly be combined with a portion of active management to mitigate total costs.

Some of the best value savers can get is in overall financial planning, and tailoring this to their circumstances and risk preferences. Many savers also see social aims as an integral part of their financial planning, and delivering this needs voting and active management. Also, a good understanding of one’s own attitude to investing can help to create a stable asset mix that reduces transaction costs. Even many professional investment managers recognise the value of independent advice when it comes to their own long term financial planning.

Investors should try to understand their overall costs, and benchmark them against likely investment returns. But it is getting the mix right that matters, not cutting corners. The intervention of regulators is welcome, but will work best if investors do some homework on the new information they get.

A version of this article was published in Personal Finance in The Herald on May 31 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds.

Image credit: Clip Art Library Piggy Bank Created by ‘gringer’.
Some rights reserved.

Published on WordPress June 2 2014

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