When it comes to getting the best return on one’s investments, the focus on fees and the impact of investment costs has grown dramatically. The result has been a growth in lower-cost index funds.
The view that higher investment costs lead to lower returns is not without merit, of course, since it is a basic rule: the higher the costs, the lower the returns. When it comes to investment and fund managers, and all things being equal, lower costs mean a greater probability of winning the long-term investment race.
But all things are not always equal, and the notion that there is always a negative relationship between investment costs and net returns is really only half the story.
I recently took a closer look at the relationship between investment cost and return, and made two interesting discoveries. One, lower-cost funds will not always outperform higher-cost funds, and, two, in some cases, investments with higher fees consistently outperformed ones that charged lower fees.
Understanding these cost-return intricacies can be very useful when taking investment decisions.
What the numbers reveal
I studied unit trust funds’ cost and return data from 2007 and in just about every period and fund category there were low-cost funds that underperformed. In certain categories, higher-cost funds consistently outperformed lower-cost funds such as exchange-traded funds (ETFs). Basically, the general rule of thumb that lower cost funds perform better breaks down in certain cases. Furthermore, the cost-return relationship has a greater chance of conforming to the general rule the longer the time period.
When I plotted the net returns of various fund categories on a scatter plot graph, I made a few interesting findings about the relationship between the cost of and return on these investments.
Diversified equity funds
Actively managed diversified equity funds dominate the general equity landscape in South Africa, and crunching the data brought three interesting points to light.
- The returns on lower-cost equity index funds don’t vary all that widely, which means that it doesn’t matter all that much which one you choose. The return on your investment won’t be affected too much by your choice.
- When it comes to actively managed diversified equity funds, fund performance can vary widely.
- The performance of equity funds that are actively managed with a quantitative investment strategy lies somewhere in the middle. While the return difference within quantitatively managed funds is greater than that of index funds, they experience significantly lower return dispersion than actively managed funds.
A key takeaway for investors in this category should therefore be that, while cost is important in all investment decisions, the portfolio management approach will drive the cost-return relationship.
Property funds
An analysis of listed property or real-estate funds also showed that there are exceptions for every investment rule of thumb. In each of the periods analysed, higher-cost funds tended to outperform their lower-cost counterparts.
There is a shortage of index funds in the property or real estate fund category, and the make-up of the fund category and the diversity of portfolio management approaches can influence the cost-return relationship.
Bond funds
The cost-return relationship across South African bond funds is fascinating. In fact, data for the three years ending December 2019 showed that there is no overall relationship between cost and return.
However, when I compared actively managed funds (multimanager bond funds excluded) and passively managed funds, actively managed funds had a surprising net return advantage.
Bond funds as a whole had a slight cost advantage (they were 0.31% cheaper on average) but underperformed the single manager active bond funds by 0.58% after costs. Actively managed funds, however, stood up well against passively managed funds after costs were deducted. Here, the All Bond Index’s coverage of the asset class is incomplete, which means that active managers are able to scour the full universe of opportunities to outperform. The lesson here is that the benchmarks themselves need to be assessed and understood before deciding to go the passive route.
Therefore, using the lower-cost-wins rule would not have benefitted investors in the local bond category either.
Money market funds
Money market funds are a most homogenous category, and it’s evident that cost plays a major role in the net returns they deliver. I found that this was true over three, five and 10 years. This means that, for investors selecting a money market fund, cost should matter greatly.
Multi-asset high-equity funds
Last, but not least, multi-asset portfolios warrant scrutiny, as most retirement fund members invest via this fund type. When looking at the data for the five years ending December 2019, we see, as expected, that there is an inverse relationship between cost and returns.
What is interesting though is that all the funds that performed better also had below-average fees. Thus, portfolio management skill and below-average fees make up a powerful combination for balanced investment fund success.
Investment costs are and should be front of mind for investors. Blindly following the cost-matters hypothesis could lead to sub-optimal decisions. It is actually better to focus on the specifics of a particular investment decision than follow a general rules of thumb.
Collin Nefdt
Collin Nefdt is a Senior Investment Specialist at Old Mutual Corporate Consultants.
The above investigation looked at historic investment performance. Past investment performance is not an indication of future investment performance.