Investors are often told of the wonders compounded returns will work on their savings, but not the damage compounded fees will be wreaking at the same time.
Many are willing to pay extra for investments that are actively managed to beat the market, and it can be worth it if a fund outperforms cheap trackers enough to justify the expense.
The trouble is, it’s hard to predict which active investment managers can pull this off. The downfall of Neil Woodford is a sobering lesson in the dangers of trusting star stockpickers.
Here, James Norton, senior investment planner for fund provider Vanguard, explains how compounded fees can deplete your wealth if you don’t keep costs down.
Investment growth: The ‘magic of compounding’ has a dark side
You have probably heard of the incredible power of compounding – the way your investments multiply over time because you earn a return on both your original investment and on the growth in that investment.
But you may not be aware that the magic of compounding can be seriously eroded by investment costs.
Take a global index fund bought through a low-cost platform with total fees of 0.4 per cent a year, compared with an active multi-asset fund purchased through a high-cost platform at 2 per cent a year.
James Norton: ‘Costs can kill your investment returns’
The difference may not seem like much over one or two years, but it will add up over time and could end up costing you a small fortune.
Our calculations show that it could mean you have nearly £180,000 less to spend in retirement. Imagine what you could do with this extra money. Would it be enough to change your life?
Or, if you are saving for your children’s education, it could mean they head off to university with £5,000 less in their bank account. That would be enough to cover their living costs for half the year.
Costs can kill your investment returns, which is why studies suggest low costs are the best predictor of superior performance in the long run.
To think of it another way, an investment fee of 2 per cent is like starting a 100-metre race 20 metres behind the start line. It’s simply a drag on performance that the manager needs to overcome, just to break even.
What happens to £100 invested for 50 years?
Here’s how the compounding of costs works in practice. Imagine you put £100 in a fund invested in the stock market and your money grew by 5 per cent over the year, but you paid costs of 2 per cent.
After one year, your initial investment would be worth £103 (£100 capital plus £5 of growth minus £2 of costs).
There is, of course, no guarantee that you would earn a positive return when investing in the stock market, but we assume your investment continues to grow by 5 per cent a year.
The passive versus active fund debate
Tracker funds are known as ‘passive’ because they follow the performance of the world’s biggest markets but don’t try to beat them, writes This is Money.
Investors pour money into such investments because although they only match index performance, they are far cheaper than ‘active’ funds.
Tracker providers keep their costs down by either just buying up all the stocks in an index or using complicated financial instruments to clone market performance.
Active fund managers pick investments more selectively with the aim of outdoing the market. However they often still underperform despite charging a lot more.
Fans of active funds argue that a good manager is easily worth the extra expense because he or she will deliver returns well in excess of those generated by trackers.
The trouble for the amateur investor is working out which are the best managers. Read more about the pros and cons of active and passive funds here.
By the end of the second year, you would have £106.104 (£103 capital plus £5.15 of growth minus £2.06 of costs).
And at the end of the third year, your investment would be worth £109.30 (£106.10 of capital plus £5.30 of growth minus £2.12 of costs).
After 50 years, your investment would have grown to £438 after costs. This shows how your investment builds up over time because you are earning a return on both your capital and the previous year’s growth.
But your costs also escalate as the fees apply to an ever-increasing sum of money. Over 50 years, if your investment had not incurred any costs and grew at 5 per cent a year, it would be worth £1,126.
That’s well over double what you would be left with after high fees of 2 per cent a year. Think how big a difference this could make if applied to your pension or savings for your children.
How do fees affect your retirement fund?
The impact of costs is most stark when you are investing for a long-term goal, such as funding your retirement.
Imagine you started saving £250 a month from the age of 21, with a view to retiring at the age of 68.
The chances are that you may need to save for even longer, given increases in life expectancy, but here we assume you invest for 47 years.
If your investments grew by 5 per cent a year in a low-cost fund with fees of 0.4 per cent a year, you would have a pot of £484,659 by the age of 68.
Choose a high-cost fund at 2 per cent a year, by contrast, and your investment would be worth only £305,309 – a difference of £179,350.
This difference could mean you have 50 per cent more income in retirement. The larger fund could provide an income of around £12,300 a year based on current rates for annuities (which provide a guaranteed income for life), compared with only around £8,000 for the smaller fund.
Number crunching: Vanguard calculation based on an investment of £250 a month in a fund with 0.4 per cent a year fee versus one with a 2 per cent a year fee
What about investing for your children?
It isn’t only at retirement that costs matter – the impact adds up even over shorter periods.
Imagine you invested a lump sum of £10,000 for your child after they were born and left it to grow until he or she turned 18, when they want to use the money to fund university costs.
The investment would grow to £22,468 if costs were 0.4 per cent a year. At 2 per cent a year, however, you would have only £17,024 – a difference of £5,444.
With average student living costs of around £800 a month, this extra sum could fund your child at university for more than six months.
Ask yourself, if you pay more, do you get more?
In most areas of life, you get more if you pay more, whether it’s an expensive bottle of wine or a high-performance car.
Our examples show that with investing, the opposite is true. Higher costs can eat away at your returns and potentially derail your investment plans.
You are taking the risk of investing your hard-earned money in the stock market, so why give away more in fees than you need to? Keep an eye on costs and let the power of compounding work in your favour.
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