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With low returns, there’s one thing you can control

Time to sharpen those pencils.

“Low-growth, low-returns” sings the refrain from those at the World Economic Forum Annual Meeting in Davos. Central bankers, politicians, investors, business elite, civil society.

A feature at the event every year, Sir Martin Sorrell, CEO of the world’s largest advertising firm WPP, is generally worth listening to. He should be, given that the ad-giant sprawls across the globe and and services clients in most industries’ imaginable.

Sir Martin told a session at Davos (according to The Telegraph) that “The new normal is a low growth world where inflation is probably under too much control – I think that’s the scenario that will continue.”

Now, if we as investors accept this environment as a given, there’s precious little in our control. The JSE will list (no pun intended), like a cork in the ocean… And that’s to be expected, given the relative size of our equity market. We’re at the mercy of far more powerful global financial flows and forces. We can’t fight the tide, whether it’s coming in or going out.

So, we can ensure we’re diversified. That should be a given. We may also try hunt for returns, hoping to eke out an extra percentage point or two here or there… 

The one thing we have direct control over as investors, however, are the fees we pay on our investments. Thankfully, fees have been on a ‘downward trajectory’ for years now. It’s not just regulation, market forces have also been driving these ‘prices’ down. Gone are the days of paying 3%-plus a year for a general equity fund. And those hefty up-front (and other) commissions paid to financial advisers on complicated, poor-performing products are mercifully a thing of the past.

Yet despite the talk about fees, we haven’t needed to pay too much attention. The JSE’s been doing well and offshore investments are shooting the lights out; everyone’s happy. In a world of >10% returns, you might not worry too much about paying 2% or more per year in fees. 

But when, in the near term, you’re facing the very real prospect of single digit returns – if you’re lucky to achieve positive returns at all – every percentage point is worth gold.

There are funds in the local market – very large, prominent ones at that – that are charging more than 1% just to achieve benchmark performance (!). You probably need to read that again and think about it. You’re paying double (or triple) what passive funds charge to match the market. (Worse, some houses are now benchmarking against the returns of South African general equity funds, excluding their own funds… but let me avoid that tangent for now). Those benchmark performance fees don’t include performance fees or ‘other expenses’. Add those in, and it’s not uncommon to find general equity funds charging well over a total of 2% in annual fees.

Where does this leave you as an investor? Already some very smart economists and analysts, Peter Attard Montalto of Nomura included, are forecasting inflation in the 6.5% range this year (and higher next). This means you need returns of at least 7%, using the bare minimum fees from passive funds of 40-50 basis points a year to beat inflation. With typical active management fees of at least 1.5% a year, your hurdle is 8%, possibly closer to 9%.

But how can CPI ‘only’ be 6% or 6.5%, I hear you asking… After all, healthcare, education, utilities/rates and food (read: Woolworths Food) inflation together is far closer to double digits than it is to 5%. So, your true ‘hurdle’ to match inflation is likely something like 7 or 8%, without fees. Now add fees… see the problem?

To illustrate this, I’ve taken the investment returns over the past five years of different asset classes from last week’s column on the importance of diversification and added – technically subtracted – the impact of fees…

An investment of R100 000 made five years ago could not have achieved the compounded return of the JSE over this same period (R183 922, or the dotted blue line), because the fees are excluded for this calculation. The best case, likely, is fees of 0.5%, meaning the growth illustrated by the solid blue line. Similarly, CPI (the dotted grey line) is not the best ‘hurdle’ to be using. Rather, I’ve plotted a solid grey line which equates to CPI, plus 2%.

Screen Shot 2016-01-24 at 6.49.40 PM

The difference between the return on an investment charging 2.5% a year in fees and one charging 0.5% a year does not look huge in absolute terms, especially in the context of this five-year period since January 2011. After all, the difference is little more than R15 000! Except that’s 15% (total) over the five years that you’ve simply forgone. And, look carefully… at fees of 2.5% (yes, admittedly extreme), the difference between your return and what you would’ve achieved at fees of 0.5% a year is practically equal to the difference between your return and a more realistic inflation hurdle of CPI + 2%. Think about that. You’ve ‘lost’ nearly half of your potential absolute return. In fees.

Returning to a low growth, low return environment and suddenly you’re going backwards very quickly if you’re paying excessive fees. Look back at last week’s chart and follow the plotted returns of local bonds… That’s what low returns look like, and – again – that’s before fees!

Don’t get me wrong… I’m not saying fees are evil, nor am I suggesting we should abandon them and exist in some sort of alternate utopia where everything is free. Fees are a fact of life. But, there’s a massive difference between 1% and 2% compounded over a 10-, 20- or  30-year time horizon. The numbers are just so complicated that we often don’t take the time to fathom the impact.

Even on a relatively modest investment (R100 000) over a five-year period, the impacts are clear.

Still think fees aren’t important?

* Hilton Tarrant works at immedia. He can still be contacted at hilton@moneyweb.co.za.

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Exactly right. There seem to be a sentiment that old school fees have fallen, and now everyone is essentially offering the same products at similarly competitive rates. Also because the fee % looks so small people don’t interrogate them but if you look at the fees the old school life insurance RA’s charge (If you can actually get it out of them) 1.5%-2%+ (Ongoing fee excluding the fund fee) compared to the financial institution products 0% to +_0.6% You could easily be paying 4 times as much as you could be. The Motley Fool UK used to do a table of top ten cheapest investment vehicles, say (One for RA’s, One for TAX free savings, One for share dealing accounts ect) every few months. It would be really useful if Moneyweb did something similar.

Everyone is spoiled
Everyone wants it for free. 2% is better than 5% and 0.5% is better than 2%.
People are willing to pay 7.5% plus finance cost to purchase a house but they complain if someone take their money and make them more money which in itself is not the simplist of tasks if you go with your own business.
It seems simple, because of the people and systems in place.

So, what if I say I’ll go into business with you as the financier. I work for free, so no salary, take 10% of the profits as a “director” each year and you keep 90%?
So if you give R500 000 and I make R50 000, you keep R45 000 and for my work I’ll get only R5 000. What if I also take the risk and say I’ll gaurantee your capital so all work and risk is on me for 10% of the (company)
Would you do the work and take all the risk for 10% of a company?

Thanks to technology we can keep fees much lower, but unless you’re an expert in the field it would be wise to rather partner than pay for sales advice.

Moonie, just wondering. Are these the same financial advisers of which I have had 3, who promised saving retirement security by using them….fast forward 9 years and 4 policies from large well known companies which have barely managed to keep up with the ALSI, and that in a record bear market. To add insult to injury, massive penalties are charges to stop these polices, thus rendering them into a loss.

And what does my financial adviser say when I query??? Shoulders get pulled up.

Interestingly, my 3 year old etf portfolio average 19% per year without any financial adviser assistance?

Financial advisers are a joke. Just more salesman. Follow the advice of the greatest investor alive, a certain Mr Buffet, who also advocates ETFS. Also read Benjamin Grahams books and see what great investors think of financial advisors and their fee’s.

HS, you are rightly pointing to sales advisors.
They will pull up their shoulders because most only learn to sell the products and ideas of the companies they represent.

Is your retirement money also in the ETF’s? Not possible if you want to use a pension product as it’s Reg28 and with that you’ll find only a few fund managers,not the companies, who performs.
You find jokers in any industry but most of them hide behind a company salary.
Mr Buffet has also advocated in one direction and invested in another.

There are millions of people and but a few who even knows what ETF means, so for you Mr HS, happy investing.

To the millions more who do not willingly save, I hope you find a sales advisor at least who will turn your arm to start investing.

@HS
In one of your other comments to an article, you mentioned US investments and Compound return.
Which article was that ?

End of comments.

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