Robin Bowerman, Head of Retail at Vanguard Investments Australia.
Robin Bowerman, Head of Retail at Vanguard Investments Australia.

How lower costs can drive portfolios

INVESTMENTS are as susceptible to economic cycles as gardens are to the changing seasons.

Bonds were definitely the pick of the crop back in 2008 when the cold winds of the global financial crisis were raging around us. Conversely shares defied the inclement outlook of many a forecaster to blossom dramatically through 2009 and restore faith in the ability of sharemarkets to grow again.

But as different investment asset classes enjoy their time in the sun and then fade away as the economic cycle turns one thing remains evergreen – the fees you pay.
At times it seems fees are something of an afterthought or perhaps second order issue when it comes to investing.

A typical investor devotes more time and effort considering which share to buy or which fund manager to invest with than concerning themselves with the fees they are signing up for.

In investment circles there is an accepted wisdom that the asset allocation decision is probably the single most important decision an investor makes in terms of their portfolio’s return outcome and risk profile.

But a recently updated book by Vanguard founder, John Bogle, provides a timely reminder about the potential impact of fees – and the ongoing argument about drivers of portfolio performance.

Bogle, regarded as one of the investment industry’s true pioneers, has written numerous books but arguably his most influential work was originally penned over 10 years ago and was titled Common Sense on Mutual Funds. Late last year a fully updated anniversary edition was released where he has gone back and reviewed the work from a decade ago and updated it with the benefit of the market experiences of the past 10 years.

So it is an interesting reflection on a no-nonsense investment approach in the wake of the global financial crisis and a tough decade for sharemarket returns.

Bogle draws on both the research studies of Brinson, Hood and Beebower (originally published in 1986) to underline the importance of the asset allocation decision and the value of a diversified portfolio. But he draws on the analysis of William Jahnke who in 1997 published a challenging article that argued “for many individual investors, cost is the most important determinant of portfolio performance”.

The original asset allocation study by Brinson, Hood and Beebower did not take into account the impact of fees. Given the very low fees that large institutional investors pay Bogle argues it probably would not have changed the outcomes significantly.

But fees paid by individual investors are dramatically higher.

Bogle advocates looking at fees through a different lens to what is traditionally disclosed by the funds management industry.

Fees on managed funds are normally expressed as a percentage of assets – and can range from 0.2% to above 2.2%. While that is a wide range it is not surprising that fees at the higher end of that range don’t get investors’ attention particularly when markets are returning numbers well into double digits.

Bogle suggests different ways of looking at fees. One is to calculate the percentage of your initial investment consumed by fees over a 10-year holding period.

Another approach is to look at annual fees as a percentage of the expected annual return. This could spark some interesting discussions around return assumptions in financial planning projections.

To illustrate simply – using expense ratios of 0.2%, 1.5% and 2.2% and assuming a future market return of 10% - costs would consume 2%, 15% and 22% of your annual return. That, Bogle argues, is a serious drain on your portfolio’s performance.

Bogle – unusually – finds himself taking the middle ground when it comes to the question of whether performance is determined by asset allocation or costs.

The answer is that both are critically important but perhaps costs are not given the attention it deserves.

One thing though is clear. The more you pay in investment fees the less you get to spend in retirement.

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Robin Bowerman, Vanguard Investments Australia's Head of Retail, has more than two decades of experience in the finance industry as a writer, commentator and editor.

* Common Sense on Mutual Funds by John C. Bogle. Published by Wiley ISBN 978-0-470-13813-7.

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