Want to boost your returns by 32%? Cut your investment costs
By
MoneyWeek Editor
John Stepek May 03, 2011
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There are very few sure things in investing.
For every investment cliché, there's an exception. 'Stocks always do well over the long run' - tell that to a Japanese investor.
Even strategies that work – such as buying value stocks, or investing in small caps – can take time to come to fruition. If you don't have time on your side, that may be a problem.
But there's one thing you can do as an investor that will always work in your favour. And better yet, it improves your odds of getting a decent return from the very beginning.
The one thing every investor must do - cut your costs
If the evidence is any guide at all, then there's one thing that all investors should watch out for before they put their money to work – costs. A study last year from fund research group Morningstar found that fees matter more than anything else in terms of fund performance.
From 2005 to 2010, the cheapest US equity funds returned an average 3.35% a year, compared to 2.02% for the most expensive. At the time, the study's author, Russell Kinnel wrote: "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds."
Now the latest research suggests that UK investors are getting a raw deal on this score. According to the FT's Money section at the weekend, US managers tend to beat their peers in the UK over the longer run.
Research from Lipper found that global equity funds in the US "returned 32% more to investors in the past 15 years than similar products in the UK." And in the ten years to the end of March this year, US-based funds beat UK-based ones across every sector in the study. That includes "Japan, Europe and global bonds."
So what's the story? Are US fund managers much smarter than the rest? Harder working? More used to a culture of investing?
As I'm sure you've realised, the answer's "no". The simple fact is they're just cheaper. As Alice Ross notes in the FT, the average total expense ratio (TER) for a US fund is 0.94%, compared to 1.67% in the UK. And that takes into account the fact that the US is a larger market than the UK.
Why are US funds cheaper?
There are a number of factors behind this. For one thing, US funds are forced to have "a majority of independent board directors who have the task of keeping fees down." In Britain, the directors are employees of the fund management group. So no real incentive to cut fees there.
But the main difference is the way financial advisors get paid. In the UK, the focus until recently has been on commission. About a third of the annual charge goes to the financial advisor who sold you the fund, regardless of whether or not they are continuing to give you advice.
In the US on the other hand, the model has moved more towards people paying for advice. So advisors get their fees direct from their clients. As a result, they have no need or motivation to recommend dud funds simply because they pay a decent commission. And that means they are more likely to favour low-cost funds that will deliver better returns for their clients.
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As for those who don't want to pay for advice, or feel they don't invest enough to warrant it, there's plenty of information out there guiding them to the likes of low-cost tracker funds.
The good news for UK investors is that the Retail Distribution Review, which kicks in from 2013, should help to change this. Under the RDR, independent financial advisers won't be able to take commission any more, and will also have to be better qualified. This is going to be tough on some IFAs, and some are objecting strongly.
It's not easy when your business model is threatened. But for consumers it's hard to see a real downside to this shift. The key thing to remember is that you are paying for your advice anyway. You may not see the bill upfront, but it's being sucked out of your returns year after year after year. This way, at least it's clear whether or not financial advice is actually worth paying for.
What you can do now
In any case, it'll be all change from next year. But you don't have to wait until then.
There's a very simple lesson here. Whatever you intend to invest in, make sure you do it as cheaply as possible. It's the one aspect of your investing that you have absolute control over.
So if you want to invest in a fund, bypass unit trusts in favour of either exchange-traded funds (if you are happy to just track an index) or investment trusts (if you think an active manager is worth the money). ETFs are far cheaper than unit trusts, while investment trusts often offer the opportunity to buy £1 worth of assets for less than £1.
But it's not just about fees. You should also make sure that you invest as tax-efficiently as possible – so make sure you use your Individual Savings Account allowance each year, for example.
And make sure you aren't frittering away money on unnecessary charges – for example, over the weekend I realised that a share-dealing account of mine was racking up quarterly charges because I'd neglected to fund it with the minimum account level. Yes, it's not the sexy, 'hunting for the next 10-bagger' side of investing. But as Ed Moisson of Lipper puts it in the FT, "every basis point counts".
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