Fees can re­duce re­tire­ment sav­ings

Small dif­fer­ences in fund man­age­ment fees can be an in­vest­ment killer in the long term

Mail & Guardian - - Business - Thalia Holmes

Ire­cently came across a con­cept called op­ti­mism bias. Ever heard of it? It’s also re­ferred to as the “il­lu­sion of in­vul­ner­a­bil­ity”. Sim­ply put, it’s the idea that bad things hap­pen to other peo­ple, not to you.

It’s a cop­ing mech­a­nism em­ployed by our brains, and I sus­pect it’s the very thing that high-fee-charg­ing fund man­agers tap into when they sell you a re­tire­ment plan.

You sign up for a re­tire­ment an­nu­ity and gloss over the fees be­cause you’re sure it won’t make that much dif­fer­ence. Or, you’re con­fi­dent that your ac­tively man­aged fund will suf­fi­ciently out­per­form the mar­ket and more than make up for the fees in the long run. But when you com­pare the per­for­mance of ac­tive and pas­sive in­vest­ments over time, it turns out that it’s of­ten not the case.

The Stan­dard & Poor’s In­dices ver­sus Ac­tive Man­age­ment (Spiva) score­card com­pares the per­for­mance of ac­tively man­aged funds, in which man­agers make spe­cific in­vest­ment de­ci­sions with the goal of out­per­form­ing the in­vest­ment bench­mark in­dex, and pas­sive funds, which aim to track rather than beat the mar­ket, usu­ally by mim­ick­ing an ex­ist­ing in­dex.

The lat­est score­card showed that an over­whelm­ing ma­jor­ity of ac­tive fund man­agers un­der­per­form the mar­ket. In other words, they do worse than their pas­sive coun­ter­parts.

Over a five-year pe­riod, “84% of large-cap man­agers, 85% of mid­cap man­agers, and 91% of small­cap man­agers lagged their re­spec­tive bench­marks”, ac­cord­ing to the score­card.

A 15-year out­look showed that ac­tive fund man­agers are even less likely to per­form well, with only eight out of 100 large-cap man­agers and only four out of 100 small­cap man­agers out­per­form­ing the bench­mark.

When you con­sider that ac­tive fund man­agers gen­er­ally charge higher fees than pas­sive funds, and that there’s a good chance that they will per­form worse than the mar­ket, you start to re­alise the risk you’re tak­ing when in­vest­ing in ac­tive funds over the very long term.

“The risk is that the high fee may ac­tu­ally un­der­per­form, mak­ing for [dou­bly] worse [out­comes],” said Si­mon Brown, the founder of in­vest­ment com­pany Just One Lap.

Of course, you could pick an ac­tive fund that does re­ally well. The prob­lem is iden­ti­fy­ing it.

“There will al­ways be ac­tive man­agers that per­form well rel­a­tive to pas­sive, and this is the temp­ta­tion for in­vestors,” said Chris Rule, the head of prod­uct and client so­lu­tions at CoreShares, an in­vest­ment firm that ad­vo­cates pas­sive in­vest­ments.

“How­ever, the chal­lenge is se­lect­ing them in ad­vance. In­vestors take on sig­nif­i­cant man­ager se­lec­tion risk when do­ing so,” he said.

Look­ing at the sta­tis­tics, the chances are much more likely that you’ll pick one that un­der­per­forms rather than beats the mar­ket.

Pre­dict­ing the fu­ture per­for­mance of a fund is im­pos­si­ble. But ac­cord­ing to the Morn­ingstar Re­search Ser­vice, which pub­lished its 2018 Ac­tive/ Pas­sive Barom­e­ter in June, there’s one pre-em­i­nent in­di­ca­tor — fees.

“The sin­gle largest de­ter­mi­nant of a fund’s fu­ture suc­cess is the costs it charges,” ac­cord­ing to Morn­ingstar.

This seems to be a strong ar­gu­ment to in­vest in pas­sive rather than ac­tively man­aged funds. Be­cause pas­sive funds aim to track the mar­ket rather than beat it, your fees don’t go to­wards pay­ing an ac­tive fund man­ager and so they’re gen­er­ally lower than their ac­tive coun­ter­parts.

We have taken three sce­nar­ios — hy­po­thet­i­cal savers cur­rently earn­ing R20000 a month and sav­ing part of their salary each month for 40 years.

We have used two rules of thumb to work out how much money our savers would need to re­tire com­fort­ably. First, we used the “rule of 300”, which as­sumes that a per­son needs to save 300 times their monthly ex­penses to re­tire com­fort­ably. Sec­ond, we as­sumed that our savers would draw down a monthly amount of 75% of their cur­rent salaries in re­tire­ment. (See “What the cal­cu­la­tions were based on” re­gard­ing pro­jected es­ca­la­tions)

Work­ing on th­ese fig­ures, Ben Collins* from stealthy­wealth.co.za did some se­ri­ous maths for us, and the out­comes were sig­nif­i­cant.

Case study one: Palesa

charges 0.2%, one of the cheap­est on the mar­ket. (To check out the fees charged by each ETF, visit etfsa. co.za).

Pay­ing a fee of 0.2%, Palesa needs to in­vest about 14% of her in­come ev­ery month for the next four decades to re­tire com­fort­ably, which at the start is R2 800 a month.

Case study two: Sipho

Like Palesa, Sipho puts his money into an ETF. But he has un­wit­tingly opted for one of the most ex­pen­sive op­tions on the mar­ket. He pays fees of 0.86%.

To reach his re­tire­ment goals and over­come the ad­di­tional fees, he will need to in­vest 16.5% of his in­come each month for 40 years. That would ini­tially amount to R3 300.

Case study three: Paul

Paul has opted to put his cash into an ac­tively man­aged in­vest­ment ve­hi­cle. His as­set man­agers have as­sured him that the 2% fees would be more than made up for by the fund’s per­for­mance. Un­for­tu­nately, the fund only tracks the mar­ket (which means its per­for­mance is still bet­ter than most ac­tively man­aged funds over the long term).

To save the nec­es­sary amount and to cover the 2% fees, he will need to in­vest 22% of his in­come each month — at first, R4 400.

What this means

All three savers will re­ceive ex­actly the same amount at re­tire­ment but, to over­come the ef­fects of the fees, “Sipho would need to in­vest 18% more, each and ev­ery month, for 40 years, to get the same out­come as Palesa”, ex­plained Collins. “And Paul would need to in­vest 57% more ev­ery month to get the same out­come as Palesa.”

Our savers will re­tire with a to­tal in­vest­ment amount of R4.5-mil­lion. Palesa will have spent 14% of that amount on fees, Sipho will have spent 57% and poor Paul will have spent 100% of his to­tal con­tri­bu­tions on fees — in other words, he will con­trib­ute more than R8-mil­lion over 40 years, and he would have paid more than R8-mil­lion in fees, in or­der to de­rive an in­fla­tion ad­justed R4.5mil­lion in­vest­ment at the end.

In th­ese sce­nar­ios, our low-fee ETF in­vestor has emerged the clear win­ner. But, as al­ways, it’s not as sim­ple as that. There are ex­tra costs at­tached to ETFs that haven’t been in­cluded in our cal­cu­la­tions. Shaun Duddy, the prod­uct de­vel­op­ment man­ager of Al­lan Gray, said: “While ETFs are gen­er­ally cheaper than ac­tive funds, a num­ber of them are not as cheap as you would think once you ac­count for the in­vest­ment man­age­ment fee, trans­ac­tion costs within the ETF, trans­ac­tion costs to buy and sell the ETF, and other ad­min­is­tra­tion costs.” (See “What the cal­cu­la­tions were based on”).

But Brown said the ef­fect of th­ese ex­tra fees is rel­a­tively mod­est. “Pas­sive [in­vest­ment] is cheap and lower risk. You have mar­ket risk but you don’t have man­ager risk, and a man­ager un­der­per­form­ing the mar­ket by even just a per­cent or two af­ter fees will mean a sig­nif­i­cant re­duc­tion in re­turns at re­tire­ment. Why take the risk? This is our re­tire­ment we’re talk­ing about, not a bot­tle of wine where we can move on from one to an­other.”

Con­trary: Most ac­tive fund man­agers un­der­per­form and the fees charged for pas­sive funds are lower. Photo: Del­wyn Verasamy

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