The Great Investment Fee Scam

My car is a zippy little Audi S3, which cost a bit, but I don’t regret buying it for a moment. Driving it is pure joy.

I also know that if I could afford an Audi R8 ($358,579) it would be a lot, umm, zippier, and a McLaren 547S ($445,184), would be better still. My dream car, to let you in on my little secret, would be a Bentley Continental ($520,042 drive away).

With cars, the cliché that “you get what you pay for” pretty much always applies, as it does throughout life, in most things … except in investment management that is.

With that service, the more you pay, the less you get, for the simple but compelling reason that the price you pay comes off what you get.

Think about it. The “product” you buy is an investment return, and the amount you pay for assistance in achieving it reduces the return. The higher the price, the more it reduces the “product”.

There is no other thing on earth where that applies – where the price you pay for it eats into the product itself. Imagine if the more you paid for a car, the slower it went! We’d all be driving Trabants.

There are exceptions, of course – fund managers who charge a lot and who do a great job, so that although the fee comes off the product, the product is so great you don’t care.

But here’s the other thing wrong with the funds management industry:  it’s impossible to tell the good ones from the bad ones. Of course, we can pick the ones that have done well in the past, but that’s not very relevant. As they themselves always say, past performance is not necessarily a guide to future performance.

The problem, to state the obvious, is that the service you are buying (with a fee that is deducted from the product itself) resides in the future, and the future is unknowable.

We simply cannot tell which fund manager is going to do well next year, or the year after, and they can’t tell us either - they can only give us a marketing spiel, present their credentials and their past performances and hope we like what we see.

And they all charge different fees, but there is little or no obvious relationship between the fee and the quality of the service provided.

The fee differences are simply a reflection of the fund managers’ differing views about what the market will accept, as well as the self-image of the person running the fund.

Moreover, because the fees are often buried deep in fine print and hard to find, it’s quite difficult to compare them between fund managers.

So even if you wade through the fine print of a selection of fund managers to find out their fees or use InvestSMART’s Compare Your Fund tool, there’s no way for you to compare them apart from on size of fee and past performance. If one charges 1.5 per cent flat, while another charges 1.2 per cent plus a performance fee of 20 per cent of anything over the ASX200, how can you compare them if you don’t know their future returns? Which you can’t possibly know.

But the most important fact of all about investment fees, and the thing that is worse than all the problems I’ve just described, is that they are always a percentage of the total funds, which means they compound along with the returns.

Compound interest is the objective of all long-term investing, but it is also the point of percentage fees, the holy grail of all those who have attached themselves to the world of investing.

Here’s a simple demonstration of how that works.

If you invest $10,000 for 10 years at a compounding rate of return of 10%, you will end up with $25,937.42.

Now, let’s say you decide to hire someone to help you, and you agree to pay a fee of 1% because, well, you’re happy to hand over $100 a year, which is 1% of $10,000, because you’re too busy to do it yourself, and that’s not much to pay.

But it’s not $100 a year, or $1000 over 10 years. A compound rate of return of 9% (10 minus 1) will leave you with $23,673.64, which is $2,263.78 less than you would have made from the 10%, or an effective fee of $226.38 per year – more than double what you thought it would be.

Which is fine if the fund manager delivers 11% compound so the fee takes it down to 10%, and maybe they will. The problem is, you can’t possibly know that before you hand over your money. You’ll find out at the end of the 10 years.

Investment managers love percentage fees. Getting the regulators and clients to agree to that in the first place was one of the greatest scams in history of capitalism, up there with shampoo companies putting the word “repeat” on the bottles.

Why is it a scam? After all, it’s not a secret right? And the industry body, the Financial Services Council, put out a press release the other day proclaiming that Australia’s fund management fees were “equal lowest in the world” (which is not saying much, and they managed not to disclose what the fees actually are in the press release).

It’s a scam because customers think they’re paying $100 when they’re actually paying $226.38.

This is a very beautiful thing for any business. Hypnotising your customers into thinking that they’re paying less than half what they are paying is what you might call the true holy grail of business.

And they don’t even have to lie! The fee is 1 per cent, or 1.5%, or 2%, cross my heart. There it is in black and white in the PDS, which is a regulated document, and if you’ve got a compound interest calculator in your pocket as you wade through the document you can figure out exactly what that means.

But very few people have got that calculator. In fact, most people can’t figure out what a percentage is at all, let alone understand compound interest. Most people, when confronted with a percentage fee, will apply that to the capital being invested to understand what it is in dollars – if they bother working it out at all.

That is why if you can find a low-cost fund manager like InvestSMART who cap their management fees you will most likely be ahead of most other similar fund managers over the long run.

So there it is: the Great Investment Fee Scam is hiding in plain sight. And it’s ripping us all off.

Click here to view InvestSMART's Capped Fee range of investment portfolios.