Here equily co-founder Helen Lawton, explains the costs of investing and why it is so important to minimise these costs. She includes academic evidence on the importance of costs to investment outcomes.

It is very hard to predict where future returns will come from, but you can reasonably expect to earn a benefit from diversifying your portfolio. And you can be sure of improving your returns if you minimise your costs. Controlling costs is much easier than seeking higher returns. Costs are predictable and certain, returns are never guaranteed. For example, you cannot be sure an active fund manager charging 1% will make higher returns than a passive index fund charging 0.05%. Only the extra 0.95% in active management fees is certain.

Think about costs as a proportion of your returns, rather than as a proportion of your portfolio’s overall value. For example, if your costs are 2% of your portfolio value, and the portfolio returns 10% in a year, then your costs are 20% of your annual returns! Even small costs have a dramatic effect on your portfolio’s value in the long run, because of the effect of compounding.

The costs of investing:

Investment Platforms

Investment platforms usually charge an ongoing fee for their service, whether you make any trades or not. They may charge you a percentage of the value of assets you have invested on the platform (better for smaller investment pots), or a flat regular fee (better for larger investment pots).

Investment platforms also usually charge you a brokerage fee to make a buy or sell trade. This trading fee is usually fixed and covers the costs involved in the mechanics of trading such as stock exchange costs.

Taxes

Many governments charge taxes on the purchase of shares listed on stock exchanges in their geographic domain. Note these taxes don’t usually apply to funds.

In the UK, the government charges 0.5% Stamp Duty Reserve Tax on the purchase of UK-listed shares bought electronically (and 0.5% on purchases of £1,000 and over, when using a stock transfer form). Note investors do not pay stamp duty when purchasing open-ended funds or ETFs. More details can be found here: https://www.gov.uk/tax-buy-shares

Spreads

You have to pay a “spread” when you buy or sell an investment because the market will charge you more when you buy, and pay you less when you sell. The spread is a hidden cost, it the difference between the price you pay (the bid price) and the price you receive when you sell (the offer price).

Spreads tends to be more significant for institutional investors because they tend to place much larger trades than retail investors (this cost is known as the market impact). But retail investors should be aware of spreads as they can be quite large when buying/selling less liquid assets such as small cap companies, emerging market equities and most types of bond funds.

Fund Charges

Funds charge an annual management fee, described as a percentage of assets. These costs are usually paid daily out of the assets of the fund and cover the costs to the fund manager, of managing the fund.

There are other costs incurred by funds that are never included in the annual management fee. Funds rarely disclose these costs. They include the costs of buying and selling the individual shares and bonds inside their funds (brokerage fees, taxes and spreads). These costs are higher for actively managed funds that do a lot of trading, and lower for passive index tracking funds.

In summary, there are three types of costs involved in investing – the initial costs of setting up a portfolio (trading fees, spreads and any taxes for the initial investments), ongoing costs (platform fees and fund management fees, including hidden ones that aren’t advertised in the annual management fee); and rebalancing costs, which are the costs you incur when you buy and sell from your portfolio after it has been established.

There a trade-off between maximising the diversification of your portfolio, and minimising costs. The more individual investments a portfolio holds, the higher the costs including the cost to rebalance (it will require a greater number of trades). Larger portfolios are more suited to the diversification benefits of more granular investments because the costs of buying and rebalancing a larger number of individual investments is a smaller proportion of overall portfolio returns.

Academic Evidence on the Costs of Investing

1. “The Arithmetic of Investment Expenses.” Sharpe, W.F. Financial Analysts Journal, Volume 69 Number 2, 2013

Abstract: “Recent regulatory changes have brought a renewed focus on the impact of investment expenses on investors’ financial well-being. The author offers methods for calculating relative terminal wealth levels for those investing in funds with different expense ratios. 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.”

https://www.tandfonline.com/doi/abs/10.2469/faj.v69.n2.2

2. “Investment Management Fees Are (Much) Higher Than You Think”Ellis, C.D., Financial Analysts Journal, Volume 68 Number 3, May/June 2012

Quote from Article: “Extensive, undeniable data show that identifying in advance any one particular investment manager who will — after costs, taxes, and fees — achieve the holy grail of beating the market is highly improbable. Yes, Virginia, some managers will always beat the market, but we have no reliable way of determining in advance which managers will be the lucky ones.”

https://blogs.cfainstitute.org/investor/2012/06/28/investment-management-fees-are-much-higher-than-you-think/

3. “How Expense Ratios and Star Ratings Predict Success” Kinnel R., Morningstar FundInvestor, August 2010

Quote from Article: “Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

https://www.morningstar.com/articles/347327/how-expense-ratios-and-star-ratings-predict-success

Please note, when investing, your capital is at risk, and returns are uncertain. The information in these blog posts does not constitute financial advice and should not be considered as such.