Do Investment Costs Matter? You betcha!
Costs do matter! A lot! Whether you’re buying a car or selecting an investment strategy, the costs you expect to pay should always be an important factor in making any major financial decision.
People rely on a lot of different information about costs to help inform these decisions. When you buy a car, for example, the list price tells you approximately how much you can expect to pay for the car itself. But the list price is only one part of the total cost of car ownership. Other things like sales tax, the cost of insurance, expected routine maintenance costs, and the cost of future repairs are also important to understand. Some of these costs are easily observed, but others are more difficult to assess. Similarly, when investing in funds, different variables need to be considered to evaluate how cost‑effective a strategy may be for a particular investor. As such, the above mentioned total cost of ownership principle should be applied to investments just in the same manner as in the case of car ownership.
TOTAL EXPENSE RATIO (TER)
Many types of investment costs lower the net return available to investors. One important cost component is the TER of a fund. Similar to the list price of a car, the TER tells you a lot about what you can expect to pay for an investment strategy. Exhibit 1 helps illustrate why stated charges are important and shows to what detrimental extent fund charges drag down performance.
Exhibit 1: High Costs Reduce Performance, US Equity Mutual Fund Winners and Losers Based on Expense Ratios (%)
Exhibit 1 includes funds at the beginning of the 15-year period ending December 31, 2016. Funds are sorted into quartiles within their category based on average expense ratio over the sample period. The chart shows the percentage of winner and loser funds by expense ratio quartile; winners are funds that survived and outperformed their respective Morningstar category benchmark, and losers are funds that either did not survive or did not outperform their respective Morningstar category benchmark. US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Small Blend, Small Growth, Small Value, and World Stock. For additional information regarding the Morningstar historical categories, please see “The Morningstar Category Classifications” at morningstardirect.morningstar.com/ clientcomm/Morningstar_Categories_US_April_2016.pdf. Fund-of-funds are excluded from Exhibit 1. The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations.
Exhibit 1 above shows data shows that funds available to US investors with higher average charges (expense ratios) had lower rates of outperformance. For the 15-year period through 2016, only 9% of the highest-cost equity funds outperformed their benchmarks. This data indicates that a high expense ratio is often a challenging hurdle for funds to overcome, especially over longer horizons. It is the equivalent of having a constant head-wind in your face as you move forward. From the investor’s point of view, an expense ratio of 0.50% vs. 1.00% means savings of $5,000 per year on a $1 million account. And since such incremental investment costs are the equivalent of dragging a sea anchor, the detrimental effects compound exponentially the longer the investor incurs these incremental fund costs.
While the TER is an important piece of information for an investor to evaluate, what matters most when gauging the true cost‑effectiveness of an investment strategy is the “total cost of ownership”. Similar to the car example, total cost of ownership is more holistic than any one figure alone. It encompasses things that are readily observable, like the TER for example, but more importantly, it also adds hidden sources of performance drag that are more difficult to assess, like trading costs and a plethora of other sources not captured by the TER. It is important for investors to be aware of these and other costs and to realize that the TER, while useful, is not an all‑inclusive metric for total cost of ownership.
For example, while the TER includes the fund’s investment management fee and expenses for fund accounting and shareholder reporting, it doesn’t include the substantial cost of trading securities within the fund. Overall trading costs are a function of the amount of trading, or fund turnover, and the cost of each trade. If a manager trades excessively, costs like trade commissions and the price impact from trading can eat away at returns. Viewed through the lens of our car analogy, this impact is similar to excessively jamming your brakes or accelerating quickly. In addition, by regularly demanding immediacy when it is not necessary, the more wear and tear your car is likely to experience and the more fuel you will end up using. These actions increase your total cost of ownership. Additionally, excessive trading can also lead to negative tax consequences on the fund level, which reduces performance unnecessarily. The best way to try to decrease the impact of trading costs is for funds to avoid trading excessively and pay close attention to effectively minimizing cost per trade, i.e. strike a balance between patient trading and future expected return of each trade. Employing a flexible investment approach that reduces the need for immediacy, thereby enabling opportunistic buy and sell transactions within the fund, is one way to help accomplish this goal. Keeping turnover low, remaining flexible, and transacting only when the potential benefits of a trade outweigh the costs help keep overall trading costs down and help reduce the total cost of ownership.
The total cost of ownership of a fund is difficult to assess and requires a thorough understanding of costs beyond just only myopically looking at the TER of a fund. Just like in the car example, investors are well advised to consider the total cost of ownership for each respective investment in their portfolio.
Sources: - Morningstar
- CRSP - DFA