The Compelling Maths Behind Investment Expenses

There has been some media focus lately on superannuation performance, notably the performance of what has been called by the Australian Prudential Regulation Authority (APRA) ‘choice’ superannuation funds across the industry.

Choice funds are different from the ‘MySuper’ product. The ‘MySuper’ investment option in a superannuation fund offers a single investment option that is designed to be simple and low-cost. The Choice section are the options beyond this MySuper fund and include multi-sector funds (e.g. balanced and growth funds), single sector options and direct investments, such as shares that you buy and hold directly.

Choice funds and their returns hold two potential interests for superannuation investors. If a superannuation investor has chosen the direct management of their own investments through a self-managed super fund, they provide an interesting benchmark. Is the self-managed superannuation fund providing reasonable performance? For those investors using a retail, industry or government superannuation fund, it is interesting for them to use the data from the industry to compare with their own investment experience.

APRA have put together a Choice Heatmap, which is a database around superannuation funds with useful data about fees, performance and performance relative to a benchmark. The link is here: Choice Heatmap | APRA.

This latter dataset – the performance relative to a benchmark – is particularly useful information. If you were to be told that next year the Australian share portfolio was going to provide a return of 22 per cent, you would probably be happy. However, if you were then told the average market return, the appropriate benchmark, returned 27 per cent, you are likely to be less happy. While the adage “comparison is the thief of joy” might be sage life advice, when it comes to investing and checking that your investments are performing as they should be, comparison is a worthwhile step.

Benchmarking Fees

The funds are grouped into asset classes based on the level of growth exposure. I have chosen to look at the 60 to 75 per cent growth asset category, as I suspect that many people’s asset allocation will fit this category – and as I look down the funds in this category, many are described as ‘balanced’ or ‘balanced-growth’ funds.

There are also a number of ‘life stage’ or ‘lifecycle’ style investment options. These are usually funds that adjust your asset allocation automatically as you age. While they might be a useful option for some, an engaged investor who can make the choice around appropriate asset allocation for their age while also considering market conditions might find themselves ahead – for example, by not automatically selling growth assets as they move into an age when a more conservative asset allocation is mandated at a time when markets have fallen.

Over the past eight years, the net return from the 60 per cent to 75 per cent growth funds has averaged around 6 per cent per annum. Using real world money, that would have turned $10,000 into $15,400. Given that this included the COVID-19 downturn, I suspect this is a reasonable result for investors who stayed the course. There was, however, a significant spread of returns, ranging from 8 per cent and more (the top fund returned 9.86 per cent) down to 2.37 per cent per annum over the eight years.

It might be of interest to look at the group of the top and bottom performing funds, with a focus on both performance and fees. The 15 best performing funds in the 60 to 75 per cent growth category provided returns of between 6.92 per cent to 9.86 per cent per annum. The 15 worst performing funds in the 60 per cent to 75 per cent category provided returns of 2.37 per cent to 3.56 per cent per annum. That is a significant difference in returns.

The following table sets out the fees for the best and worst performing funds, based on the total fees disclosed on a $100,000 account. On average, the fees on the best performing funds come to just over 1 per cent per annum. The worst performing accounts had fees twice this level, just over 2.1 per cent per annum.

The Importance of Fees

William Sharpe, the 1990 Nobel Laureate for Economics, has some thought-provoking observations about the impact of fees on investment returns.

He splits the overall share market into two groups: those using a passive (index) approach to investing and those using an active approach (market timing and stock selection).

Let’s say that over a period of time the average market return is 10 per cent pa – which is a reasonable approximation over periods of time for the Australian market. It does not particularly matter how the market is split between the active and passive investors, however, let’s say that the market is 80 per cent active and 20 per cent passive.

The average investor in the passive part of the market, using index-style funds, is going to receive a return equal to the average market return, less a little bit in costs. They will receive 10 per cent per year, less a little in costs.

That means that the average return on the active part of the market must also be 10 per cent per year. However, investors in this part of the market are paying for all the significant fees in the financial services industry – brokerage, research, fund manager fees, hedge fund fees and so on. The average return for investors in this part of the market will be the 10 per cent, less their higher rate of fees.

The mathematical reality is that active investors, on average, will make less than passive investors.

“Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling. Under plausible conditions, a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments,” Sharpe wrote in a 2013 paper titled ‘The Arithmetic of Investment Return’, published in the Financial Analysts Journal.

It is interesting to see someone of William Sharpe’s intellectual standing, someone who has studied investments markets through their life, focus on a phenomenon as simple as fees – and emphasise how important fees are in returns.

Conclusion

Data of interest, benchmarking of returns, and a reminder of the importance of fees are three takeaways from looking at superannuation returns from the APRA Choice Heatmap. As a database that can be sorted by asset allocation, containing information about fees, returns and asset allocation for superannuation funds, it might be a resource worth spending a little time with. In terms of fees, we can see that better performing funds had significantly lower charges at around 1 per cent per annum. This is something investors can use to benchmark their own portfolio fees, whether in a self-managed super fund or the superannuation fund they use.