Cutting costs may be one of the most effective ways to increase investment returns this year. To be sure, some investors have been riding a wave of positive market momentum over the past year as lower central bank policy rates have broadly boosted asset prices and seemingly contributed to easy investment returns. While monetary policy could be supportive of risk assets in 2020, we expect prices to remain susceptible to quick reversals as markets remain near historic highs. In fact, this was illustrated last week as news of the coronavirus’s global spread caused a pullback in financial markets.
We believe that last week’s market selloff also serves as an important reminder to investors that the momentum that had contributed to easy market gains are likely to be challenged this year by weaker economic fundamentals, softer earnings and already stretched valuations. In such an environment, we believe that investors have a better chance of increasing their returns by managing fees and managing risks in their investment portfolios.
Figure 1: Lower fees can increase investment returns
Addition by subtraction
So how can managing fees improve investment returns? Well, simply put, the higher the fees charged to an investment account, the lower the base from which a portfolio can appreciate. Or put differently, fees tend to reduce the amount of money that can be put to work and compounded over time. To illustrate this point, we compare the performance of two hypothetical portfolios that have varying fee structures.
Figure 1 above shows two portfolios valued at $250,000, each compounding monthly at a hypothetical annual rate of 5%, but with different fee levels. Annual product fees in Portfolio 1 average 1.0% and have asset management fees of 1.5%. This compares with annual product and asset management fees each of 0.5% for Portfolio 2. In aggregate, this is 1.5% less than the first portfolio. So how do they compare?
Figure 2 illustrates a notable divergence in the value of Portfolio 2 over its peer across our 10-year test period. More specifically, the gains attributed to lower product and management fees added up to over $52,000 over the test period and made for a difference of 16.2% between the two portfolios. This suggests that not only do lower fees contribute to higher compounded returns, they also reduce the amount of time it takes to achieve financial goals.
To this point, we know that it took 10 years for Portfolio 2 to increase from $250,000 to a value of $372,000. How much longer would it take Portfolio 1 to achieve this value given the same sort of assumptions in our previous example? At higher fee levels, Portfolio 1 would need to compound at its current rate and fee structure for six additional years to attain the value that Portfolio 2 had achieved in 10 years. That’s arriving at a financial goal six years sooner and illustrates the rules of exponential growth applied to savings goals.
Figure 2: Lower investment fees contribute to higher exponential growth
Ways to manage and reduce investment fees
So then what steps can investors take to cut costs and increase investment returns in their portfolios? Well, we suggest that they begin by looking at how much they’re being charged by the products held in their investment portfolios. We have found that actively managed mutual funds tend to charge higher fees than passively managed exchange traded funds (ETFs). This is important because active managers have had a track record of underperforming their benchmarks over the past decade. And from this perspective, investors may be better served by paying for indexing than by paying to time the markets.
Beyond managing product costs, we recommend that investors take a close look at the fees they are paying to their asset managers. These fees, typically charged on an asset under management (AUM) basis, vary widely among asset management firms and can rise or fall based on the size of an investment portfolio. Therefore, we recommend comparing your AUM fees against industry averages, and pay particular attention to the breakpoint levels that may qualify you for a lower fee if your portfolio has appreciated in recent years and your AUM fee remains unchanged.
If the fees you are being charged are above average and your asset management firm cannot clearly articulate the value-add of their higher management fee, then we recommend evaluating potential alternatives. In this increasingly commoditized business, some alternatives would include firms with a lower cost AUM structure or those that charge a flat asset management fee.
Either way, in an environment where market volatility could potentially rise in the months ahead, we believe that investors are best served by managing risk in their investment portfolios. This is done by rebalancing allocations to their long-term investment objectives. From the perspective of managing fees and increasing investment returns, the act of addition by subtraction, that is, reducing the amount of money flowing out of a portfolio, we believe can contribute to higher overall portfolio values and reduce the time it takes to grow assets to a target level.