By Tony Kaye, Senior Personal Finance Writer, Vanguard Australia
When it comes to investing, there are things you can never control and things that you can.
You can't control what happens on financial markets on a day-to-day basis or the market returns from your specific investments.
But you can control one of the most important things of all that ultimately affects your returns – the costs that you pay to invest.
Costs are a factor that many investors overlook.
"Investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs; costs that ultimately overwhelm that magic," noted Vanguard founder John C. Bogle in his bestselling 2012 book The clash of the Cultures: Investment vs. Speculation.
In short, every dollar that you pay in costs is a dollar out of your investment return. Or, put the other way, lower investment costs mean more money will end up in your pocket over time.
When choosing any professionally managed investment product, it's very important to be aware of the costs you're being charged.
Higher costs on investment products don't add up to better returns. It's the opposite in fact. Over time, higher-cost products will give you lower returns because they're taking away more cash from you.
Management fees are charged irrespective of the investment returns a product achieves and are deducted from your total investment return.
Product costs are usually referred to as the management expense ratio, or MER, and must be disclosed in a product disclosure statement and periodic statements.
A product's MER includes management fees and other expenses such as transaction charges, account fees and other operating costs, and is normally shown as a percentage of every dollar invested.
For example, for a managed fund product with an annual MER of 0.1 per cent, the base cost for every $10,000 invested is $10.
Compare that with a managed fund with a MER of 0.5 per cent. The cost on the same amount invested is five times more – $50 a year.
Some investment products currently in the Australian market have MERs above 3 per cent a year. A high percentage charge fees above 1.5 per cent a year.
Keep in mind that your total cost of investing based on a product's MER will compound as your investment grows over time.
Again, using a $10,000 example and a five-year investment period, a managed fund product with a MER of 0.1 per cent that achieves investment earnings of 6 per cent a year would end up costing $66 in fees. At a 0.5 per cent MER, your costs would be $329.
Fees increase as your investment value increases, reducing your investment balance over time.
Here's how those calculations would look over the five years.
|Year||Investment Balance||Fees||Investment Balance||Fees|
|At year 1||$10,589||$11||$10,547||$53|
|At year 2||$11,214||$22||$11,125||$111|
|At year 3||$11,875||$36||$11,734||$177|
|At year 4||$12,575||$50||$12,376||$249|
|At year 5||$13,316||$66||$13,053||$329|
See how, because of its lower fees, the investment balance on Product 1 after five years is more than $260 higher than that of Product 2.
On a 3 per cent MER, the charges on a $10,000 investment over five years (also based on a 6 per cent annual return) would be more than $1,800.
You should also be aware that some investment products charge performance fees on top of their standard management fees.
Products with performance fees charge them if they generate a positive return over a certain percentage level. Performance fees can be 20 per cent of any excess profits that are made, or even higher in some cases.
Vanguard Australia recently surveyed more than 1,000 Australians aged over 18 on their attitudes and approaches to investing.
Asked whether they consider costs in their investment choices, 61 per cent said they do each time while 29 per cent said only sometimes. Ten per cent said they never consider costs.
"It's Vanguard's long held view that planning, discipline, keeping costs low and maintaining a long-term perspective are the key things that give investors their best chance for success," says Vanguard's Head of Personal Investor, Balaji Gopal.
While fees on investment products can't be totally avoided, you can control which products you choose to invest in.
Do your research and, as part of that, look for comparable products that charge lower fees than others.
It's important to compare apples with apples to ensure you're getting the same investment coverage.
It's easy to compare investment products fees, and Vanguard has a managed fund fees calculator on its website so you can calculate the fees you'll be paying over time.
A few percentage points in costs may not seem like a lot.
But, on larger investments amounts and over longer time periods, those extra costs will really start to add up and reduce your investment returns.
Next week we'll address the question: how often should you check your returns?
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