Brent Sheather: Torture file

What's the rationale for focusing on fees? Photo / iStock

Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

There is an old saying, popular with economists, that if you torture data sufficiently it will confess to anything. Whilst torture is illegal and NZ is a signatory of the Geneva Convention not everybody is playing by the rules.

A recent atrocity occurred in a newspaper article where a commentator compared the returns from low risk/low fee KiwiSaver funds with those of high risk/high fee KiwiSaver funds, noted that the funds with higher fees had outperformed and thus concluded that the data showed that investors placing undue emphasis on fees were misguided.

Well, well, well let's see what the facts say, absent the duress.

The major problem with this analysis, obvious hopefully even to the novice KiwiSaver investor, is that as shares are more risky than money in the bank or bonds they can reasonably be expected to outperform cash and bonds.

Indeed the 2016 iteration of the Global Investment Return Yearbook (GIRY)tells us that since 1900 the US stock market has returned9.4% pa versus 4.9%pafor US bonds. It is the same story in NZ - in real terms the NZ stock market, since 1900, has returned 6.2% pa, well above the 2.1% pa real for NZ bonds. It is thus pretty obvious that the commentators comparison of the return from shares with low risk/low return asset classes tells us absolutely nothing about fees except perhaps that the investment industry, bless its black soul, know that they can inflict higher fees on share market investors than bond investors.

Contrast this commentators "returns are independent of fees" mantra with the real world.

Numerous research papers show what is pretty obvious to anyone with half a brain and that is the higher the fee the lower the return to the investor, on average.

One of the most widely read of these papers was entitled "On persistence in mutual fund performance" by Mark Carhart, published in the Journal of Finance. He tested the theory that "mutual fund managers claim that expenses and turnover do not reduce performance".

Expense ratios, portfolio turnover and load fees are significantly and negatively related to performance. Expense ratios appear to reduce performance a little more than one for one.

He found that "expense ratios, portfolio turnover and load fees are significantly and negatively related to performance. Expense ratios appear to reduce performance a little more than one for one". He concluded that "while the popular press will no doubt continue to glamorize the best performing fund managers the mundane explanations of strategy and investment costs account for almost all of the important predictability in mutual fund returns". Recall also the telling statement by an equally uncompromised, unbiased executive of the Pensions Institute at the Cass Business School a while ago, quoted in the Financial Times who said "there is little academic evidence to support the argument from advisors that asset management and the potential for outperformance is more important than cost".

So there you go - there is of course a relationship between fees and returns but as common sense would suggest it is negative not positive as the commentator might have us believe. In other words the more you pay in fees the less that is left over for you.

The commentator did make the valid point that all things being equal younger people should have more money in growth assets and the statistics certainly suggest too many KiwiSavers are in low risk, low growth funds which is inappropriate given their long term investment horizon. Having said that not every 20 year old should be in a growth orientated KiwiSaver fund - if they are saving for a house and they intend to buy that house in five years or so then a low risk fund is a sensible and rational choice. This however is a different and totally unrelated issue to fees.

According to a study last year up to half the funds in some European countries charge their investors for active management but their portfolios look like the benchmark.

Coincidentally the Financial Times (FT), last month, reported that four out of five of the most popular fund managers last year were big players in the low fee passive fund area. Investors are voting with their feet and favouring low cost funds unburdened by performance fees and with low turnover.

What's the rationale for focusing on fees?

It is this - given that there are so many people trying to find bargains on the stock market - think institutions, fund managers, retail investors, insider traders, company executives etcetc it is difficult to find bargains. Sure some people outperform for a year or five years or even more but sooner or later their luck runs out or some extraordinary factor changes.

In NZ, for example, a few years back some commentators pointed to the outperformance of local fund managers but this was, in most cases, just due to the fact that most fund managers underweighted Telecom back then as a risk management strategy, because it was such a big part of the market.

Thus when at that time Telecom underperformed fund managers naturally looked good. Globally fund managers are normally overweight higher risk small companies so when these companies outperform they look good. Other people, usually fund managers or their puppets, argue that when you can see the market going down fund managers have the ability to move to cash so should naturally outperform in falling markets.

This sounds feasible but the facts don't support the argument.

Maybe a road map for the FMA here given that their mandate is to ensure that investors get a fair deal.

The reason is simply because it is difficult to know when the market is going to go down and how long it is going to go down for. People typically move to cash which looks good for a couple of days then the market bounces by 4% or so and they miss the bounce.

The fact that "high fees are not good for your wealth unless you are a fund manager" is pretty well acknowledged in most markets. In fact overseas regulators, notoriously slow to figure out what is happening in markets have started to advocate for low fees.

The SEC website contains a warning to private investors, according to Investopedia, that "higher expense funds do not on average perform better than lower expense funds". The FT reports that in Europe investors are rebelling against index hugging where fund managers purport to manage a portfolio but really just organize it according to what the index looks like.

"According to a study last year up to half the funds in some European countries charge their investors for active management but their portfolios look like the benchmark".

In Scandinavia the Norwegian Consumer Council is planning a law suit on this basis against the country's biggest bank and this is after the Norwegian regulator ordered that bank to either get active or cut the cost of its funds.

The FT concluded that "regulators in Europe are getting bolshier about investing costs and more than ever fund managers need to show they are worth their fees or investors will take their cash elsewhere."

Maybe a road map for the FMA here given that their mandate is to ensure that investors get a fair deal.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.