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Investment costs matter. In the context of a finite market return, investors fall short of the total market return by the total investment costs they incur.
Whatever the financial service industry charges for administration, advice, commission, trading, investment management or performance is at the expense of the client’s return.

In this zero-sum stand-off, the “fees must fall” slogan should also resonate with investors. It is they, after all, who provide all the capital and take all the investment risk; they are entitled to expect the lion’s share of the investment return.

For many retail investors that is not the case. The average policy-based retirement annuities (RAs) sold by the large insurance companies cost close to 3% pa, made up of around 0.75% for advice, 0.25% for administration and 1.5% for investment management (plus VAT).

In a previous, less enlightened time, uninformed investors could be excused for believing that despite this heavy levy they still kept most of the profits. This was when South African inflation ran well into double figures and the industry was allowed to project nominal (before inflation) returns of 15% pa on a balanced portfolio. Ostensibly, paying 3% pa suggested that investors kept 80% of the return.

But that is not the way the maths work out. In the context of a consistent 40-year savings regime, someone paying 3% in fees rather than 1% pa receives almost 50% less money at retirement. For example, saving R1,000 pm for 40 years earning a nominal 14% pa after-fee return generates R17,2m, earning 12% pa only R9,8m. That is the harsh reality of investment costs: they compound in an unexpected and dramatic manner, and have a disproportionate impact on the long-term savings outcome. John Bogle, the pioneer of index investing, calls it the ‘tyranny of compounding costs’.

The fee impact is not diminished in a high return environment. However, restricting fees is more critical when real (after-inflation) returns are low, if investors are to achieve their retirement goal.

The typical retirement formula “save 15% of your income for 40 years” assumes that retirement fund members earn a net real return (after fees and inflation) of at least 3% pa. Over the past forty years, a balanced high equity portfolio would have delivered a gross real return of 6%. Adhering to a diligent savings plan and an optimal portfolio, savers could thus have (just) afforded fees of 3% pa. But, few savers tick both boxes, which means most would have been carried out by those fees even during the best of times.

Those heady returns may not repeat. Prudently, investors should not expect to earn more than a 4% pa long-term real return on a balanced portfolio, which means that even if they follow an optimal savings plan, they will not reach their retirement goal paying 3% or even 2% in fees. The equation simply will not balance, unless they are prepared to save upward of 20% of their income.

Future fund manager returns are unknown, but fees – or the expense ratio – is the most proven predictor of future fund returns, as anyone who follows Morningstar's research will know. Its latest study reconfirmed this yet again: the expense ratio helped identify the better-performing funds in every asset class and in every quintile from 2010 to 2015. Among US equity funds, for example, the cheapest 20% of funds were three times more likely to survive, or deliver above-average returns, than the most expensive 20%.

It is not surprising that the industry does not enjoy the fee debate. It puts an uncomfortable spotlight on the subject of ‘value for money’. This illumination debunks one of the industry’s enduring marketing myths - that you get what you pay for - and threatens the industry’s lucrative business model. This is already happening in the US, where money managers are beginning to look at merger opportunities to retain scale.
High fees nourish the illusion that investors pay for the fund manager’s skill, much like people pay premium rates for the professional services of a lawyer or doctor. This may have been true in earlier times, when a handful of professional managers came up against a mass of armchair investors and speculators. In today’s world, however, the experts compete amongst themselves. Although individually very competent, within their peer group they lack a demonstrable talent to consistently beat the average or market return.

There is the rub. The market return can be had at low cost, by investing in an index fund. Once investors know this, they will question the value of paying higher active management fees. According to the evidence, the average investor receives no value for those higher fees.

While the first rule of the high fee investment club is seemingly to not talk about fees, these do have to be disclosed. Mere fee disclosure is not enough however, especially in light of Treating Customers Fairly (TCF) requirements. That is no different to the tobacco industry indicating the level of nicotine in cigarettes, without warning of the addictive nature of nicotine and the dangers of smoking.

Investment products require a similar (financial) health warning. Investors should be alerted to the long-term effect of the fees they pay, by quantifying the impact on their savings outcome. For the sake of transparency, all fees deducted should also be evident on their benefit statement, showing how much of their savings are invested and how much of the gross return they keep.
The problem is that there are no laws to such effect and many investors thus remain unaware that they may be the victim of blatant and unfair overcharging, which is the very definition of daylight robbery, – ‘blatant’ because the industry does not guarantee higher returns for higher fees and ‘unfair’ because investors are not alerted to the gradual dismantling of their retirement wealth by such fees.

Steven Nathan is the CEO of 10X Investments.
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