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What Really Destroys Your Investment Returns

I was out having lunch yesterday with a group of friends who are working in the finance industry. Over our meal, the conversation drifted over to sovereign wealth funds and how some of their investments are structured.

As it turns out, some SWFs hire managers to select funds of funds – and this arrangement results in three layers of fees. The funds’ managers are paid a fee; the funds of funds’ managers get paid a fee; and then the managers who select the funds of funds get their slice at the top.

I won’t get into the performance of the SWFs but let’s just say that with a three-tiered cake of fees, the bar to overcome before the SWFs can earn a decent return has been set really high. This reminded me of what can really destroy the individual investor’s returns – a lack of focus on the fees that’s being charged by managers who manage your funds.

With a fund of funds, your returns ain’t fun

In 2008, billionaire investor Warren Buffett made a 10-year bet with asset management firm Protégé Partners. Part of Protégé Partners’ expertise resides in building a portfolio of hedge funds – in other words, the firm helps build fund of funds. Buffett’s bet with the firm was that a low-cost fund tracking the S&P 500 (a broad market index in the USA) would outpace Protégé Partners’ fund of hedge funds – and for a simple reason. In Buffett’s own words:

“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors [emphasis mine].”

We’re only half-way through the bet, but at the end of 2013, Buffett’s low-cost S&P 500 index fund had gained 43.8% while Protégé Partners’ hand-picked group of funds had turned in a measly 12.5%.

With investors in Singapore, those pesky fees we need to pore

I think more investors in Singapore need to recognise the pernicious influence that fees can have on our investment returns. In 2013, Morningstar did a study and found that the average equity-based unit trust in Singapore carried an annual expense ratio of 1.94%. The 1.94% figure might not seem like much. But over time, it adds up significantly.

Consider a fund which would grow at 8.5% annually over the long-term. I choose 8.5% for a reason. I think it’s a reasonable figure to look at because the SPDR STI ETF (SGX: ES3) has delivered total annual returns (where gains from reinvested dividends are included) of 8.39% since its inception on 11 April 2002.  The SPDR STI ETF is a low-cost exchange-traded fund (the ETF has an annual expense ratio of 0.3%) which tracks Singapore’s market barometer the Straits Times Index (SGX: ^STI). The chart below shows how much of your returns you would have lost to the fund manager with an annual expense ratio of 1.94%.

effect of expenses on returns

Source: Vanguard

As seen above, a holding period of 10 years would have cost you 31.3% of your returns if the unit trust had charged an expense ratio of 1.94%. For a $10,000 initial investment, that’s $3,952 in returns that the unit trust charges!

Fortunately, the situation about high fees here seems to be improving. At the very least, the CPF Board in Singapore is lowering the limits on the expense ratios that unit trusts and other investment funds can charge if they would like to remain under the CPF Investment Scheme (CPFIS). For me, this change couldn’t have come sooner enough.

I said it earlier and I’d say it again. When investing, keep your eyes on fees. It’s what can really destroy your investment returns.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.