Reducing investment costs can have a major impact on expected returns in your retirement and/or investment portfolio, more so than many people realise. Investing in a fund where the manager is paid big bucks to speculate on individual stocks and market timing (a technique known as "active" management) is not only hit-and-miss in terms of the final results, it is also expensive.
Studies show that 7 out of 10 Active managers fail to achieve their remit of beating their index benchmark. The 3 managers that did achieve their remit often then fail to do so for the subsequent period. Active funds also typically cost up to 100% more than index investments that aim to pay you the returns the overall market has to offer. Those fund manager salaries involved in active fund management don't come cheap and somebody - usually meaning you, the final investor - has to pay for them in charges. Total expense ratios or TERs (meant to show final cost to investors) of an active fund are typically around 1.8% annually. Okay, that might not sound like much at first. But bear in mind that for every £10,000 invested you are paying out £180 in fees. Again, while £180 may not sound like so much, those figures mushroom as people invest greater sums and do so over a period of years. Another major impact on returns are the hidden costs, known as Portfolio Transaction Ratio (PTR), that are not included in the TER but which the investor also pays for.
An FSA study into PTR costs concluded that on average this can add a further 1.8% per annum to your total costs. When added to your TER this gives you a Total Cost of Investing (TCI) of 3.6% per annum. Say you choose to invest £100,000 in an actively run fund. You would be paying out £3,600 in fees in the first year alone, potentially wiping out any performance gains. Paying out that much in fees swallows up a big chunk of any potential returns generated by the active manager. Academic research suggests that high investment charges mean investors might be better off simply investing to capture the market returns on offer through index-based solutions. Typical Total Cost of Investing (TCI) for an index-based solution are only around 1.50% per annum.
Let's see how an index-based solution's TCI compares to active fund solutions. On £100,00 invested in a fund guaranteed to give you virtually the same returns as the market of 7%, you would pay out only £1,500, compared with £3,600 for the active fund. As the years go by, of course the effect of investment fees multiply via compounding. After 20 years, the active fund value would be £195,168 compared to the index fund solution value of £291,773. That's a difference of £96,605 or 50% in just costs alone. In the investing world, costs are one of the only factors that are in your control.
Charges can eat into your investment returns and can reduce your final pension or investment pot significantly. Not only do you pay out less in charges by investing in index-based solutions. You are investing your money - your hard-earned money, remember - into an investment strategy that applies techniques pioneered by some of the worlds' leading economists, academics and Nobel Prize winners. Even the world's greatest investor, Warren Buffet, endorses index investments as the most sensible equity investment for the great majority of investors. In contrast, active management gives the individual manager discretion to gamble or speculate in how they invest your money. Performance from active funds, as you may have guessed, can be more unpredictable than their costs might have led you to hope.