Regular TEBI readers will understand the need to avoid high fees. But new research suggests that the frequency of fees can be just as important.
One of the most important lessons investors need to learn is that cost matters. The late indexing pioneer Jack Bogle often cited what he called the Cost Matters Hypothesis. To put it simply, the more you pay, the lower your net returns are likely to be. Too often, he wrote in his book Common Sense on Mutual Funds, “the miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”
However, as a new paper called The Structure and Impact of Fees on Investor and Manager Returns shows, it’s not just how much you pay in fees and charges that counts, but how often you pay them.
Researchers at University College London compared the net performance of a range of hypothetical funds with a variety of fee arrangements. They particularly focussed on the frequency with which different fees and charges were extracted.
What they found was that frequent fees — those charged monthly rather than annually, for example — had the biggest impact. "The portfolio with monthly fee collection,” the authors wrote, “loses a significant amount early on… Over ten years, the portfolio with 30% fees and monthly fee collection lost over 60% of its original capital, whereas for semi-annual fee collection, the loss was 23%.”
By charging large fees, especially performance fees, and, crucially, extracting those fees more frequently, the study found, fund managers are able to generate considerably higher revenue at customers’ expense. To quote the paper: ”Moving from annual, semi-annual, or quarterly frequency for fee collection to monthly fee collection reduces investor capital by nearly 50% at the end of the ten years for large performance fees.”
Frequent fees drain performance
Why, then, does the frequency of fees make so much difference? Because, say the authors, frequent fee collection “constantly drains positive performance, reducing gross return”. In other words, it’s compounding in reverse.
To quote the paper again: ”Too-frequent fees negate the positive effects of compounding; effectively, compounding works against the investor to benefit the manager. This effect was demonstrated with all market models that were explored. In addition, market volatility amplifies the effects of frequent fee application."
As anyone who has researched fees and charges in any detail will tell you, it’s a minefield. The charging models applied by workplace pension schemes, discretionary fund managers and large financial advice firms can be extremely complicated and opaque.
The key point is, there are all sorts of different expenses investors incur in addition to the headline AMC, or annual management charge. These include transaction costs such as dealing fees, bid-offer spreads and Stamp Duty, as well as custody charges, platform fees, valuation fees and reporting fees.
Working out your total costs can be more complicated if your adviser uses a DFM, or discretionary fund manager, that invests in underlying funds provided by different asset managers. It’s highly possible that some of the costs you’re incurring are not even disclosed.
Know how much you’re paying
For all of these reasons it’s very important that you try to understand how much they’re actually paying. Yes, pay close attention to client agreements or Key Information Documents (KIDs), but don’t rely on those entirely. If in doubt, always seek a detailed breakdown to identify less transparent costs.
As the UCL research shows, you should specifically look at the frequency of fees. I don’t recommend actively managed funds, but if you really want to use one, find out how frequently the fund has traded in the past. The annual portfolio turnover rate for actively managed equity funds domiciled in the UK is typically more than 50 percent. This means that, on average, more than half of a fund's holdings are bought and sold within a year. And remember, it’s you, the investor, who picks up the tab.
Another frequently applied cost that’s often overlooked is the contribution fee. Many pension schemes and advice firms charge a fee of up to about on each and every contribution you or your employer makes. These are usually around one or two percent, but they can be as much as five percent. And if, as most people savers do, you contribute to your pension automatically, you’re paying at least 12 separate contribution fees a year.
Another lesson from the UCL study is that performance fees in particular can seriously erode your returns over time. Investors, the authors warn, should be especially sceptical of funds that market themselves as offering steady returns with low volatility, but which charge high performance fees.
In short, understanding how fees are structured and applied is critical to making informed investment decisions. You should prioritise transparency, align fee structures with their investment goals, and minimise frequent deductions to protect your long-term returns.
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