Why Total Costs Really Matter

A fundamental mistake by investors is to pay insufficient attention to their total investment management costs. In short, high investment costs weigh heavily on returns.

Research repeatedly confirms that many higher-fee, actively managed funds struggle to beat or at least match their benchmarks over the short, medium and long term once their fees are taken into account. (See High cost of underperformance, Smart Investing, January 13.)

In an article published in the Financial Analysts Journal, John Bogle, founder of Vanguard, emphasises the toll that high investment management costs take – particularly over the long term.

In his article, The Arithmetics of ‘All-In’ Investment Expenses, (PDF) Bogle comments: "After analysing the data over many years, I feel confident in reaffirming the warning that I have consistently given to fund investors over the years: ‘Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns’."

A particular theme of this article is that investors should focus on the "all-in" or total investment costs of their managed portfolios.

Apart from annual fees charged by fund managers, there are, of course other costs that directly relate to the approach taken by managers. These include extra tax and transaction costs flowing from the turnover of securities.

"Finally, for most investors, relative tax efficiency is a critically important element of total costs," Bogle writes. "Funds with low expense ratios (notably, index funds), which operate with minimal portfolio turnover, are relatively tax efficient.

"Actively-managed funds, with their far-higher expense ratios, not only incur substantial transaction costs on their portfolio turnover but also realise capital gains, generating significant tax inefficiency," he adds.

In the short-term, the impact of costs might appear modest but over the long run, investment costs become "immensely damaging" to an investor’s standard of living.

"Think long term," Bogle urges. "For those who are investing for their retirement and their lifetimes, understanding the cost issue is vital to success in investing."

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.