Costs and fees: The enemies of profitability
When we talk about investing, it’s natural to immediately think about returns and risks. But there’s another factor that should be just as important in our decision-making process: costs and fees, which often act as the enemies of investment.
Costs and fees can significantly impact the net performance of investments and, over the long term, can considerably reduce expected profits. In his Little Book of Common Sense Investing, John Bogle emphasizes this aspect and provides some surprising examples, like this one:
“An academic study showed that the most active quintile of all investors rotated their portfolios at a rate of more than 21% per month. While they earned a market return of 17.9% per year during the periods from 1990 to 1996, they incurred trading costs of approximately 6.5%, leaving them with an annual return of 11.4%, only two-thirds of the return in that strong market rise.”
In other words, turnover costs—those incurred from buying and selling assets to vary the composition of our investment portfolio—can erase up to 30% of a fund’s expected return. And that’s assuming the fund in question yields a return worth mentioning… As Bogle reminds us, “common sense tells us that returns come and go, but costs persist.” Therefore, it is advisable to examine them carefully before contracting any investment product.
Enemies of long-term profitability
Although costs and fees may seem insignificant when considered individually, their long-term impact can be significant, as we saw in the example of the most active investors. Each cost reduces the amount of money being invested and, therefore, decreases the potential for compounded growth of the investment. This is known as the erosion of returns.
For example, consider an investment fund with a management fee of 2% per year. If an investor earns a return of 6% before fees, after deducting the management fee, the net return is only 4%. Over the long term, this 2% difference can result in a considerable loss of accumulated value: if you’ve heard about compound interest as a multiplier of your long-term gains, you can imagine the devastating opposite effect that accumulated costs have year after year…
Moreover, transaction costs can quickly accumulate if many trades are made within a portfolio. This is particularly relevant for actively managed funds, where managers frequently buy and sell assets. Investors in these funds can easily pay more in transaction costs than those who invest in passive funds, such as index funds.
How to minimize the impact of costs and fees
Given that we cannot predict the returns of any investment, the best thing we can do is control what we know in advance: the associated costs. Among the most common are:
1. Management fees: These are the charges levied by the managers of investment funds and other actively managed products. They are usually a percentage of the total invested capital and can vary significantly between different funds and managers.
2. Subscription fees: Some investments charge fees when buying (entry) or selling (exit) an investment. These can be a percentage of the amount invested or a fixed fee.
3. Transaction costs: These apply when buying or selling assets within a portfolio, including brokerage fees and other charges related to executing trades.
4. Operating expenses: These include a variety of costs associated with the operation of a fund, such as audit, legal, administrative, and other general expenses. These are often expressed as an expense ratio, which is the percentage of assets under management used to cover these expenses.
5. Performance fees: Some funds charge performance-based fees, which are activated only if the fund exceeds certain performance thresholds. Although they may seem fair, they can incentivize high-risk behavior by managers.
There are no secrets to success, but three recommendations can be helpful for most investors. The first is obvious: choose low-cost investments. Index funds usually have much lower costs than actively managed funds. In real estate, remember that investing in real estate crowdfunding with Urbanitae has no associated costs for the investor.
The second, derived from the above, is compare fees. Before choosing any product, look at the competition or the most obvious alternatives and see if, besides returns and risks, the costs are similar or there is a big difference. And lastly, invest for the long term: Bogle advocated investing once and staying out of the market: that is, “doing nothing” to let investments grow in the long term. The “buy and hold” approach can be beneficial for minimizing transaction costs and successfully combating those silent enemies of profitability: costs and fees.