Costs of Investing — How Costs Influence your Investment Returns

„Cost really matter in investments. If returns are going to be 7 or 8 percent and you´re paying 1 percent for fees, that makes an enormous difference in how much money you´re going to have in retirement“ — Warren Buffet.

Due to compound interests, investment related costs have a tremendous impact on the terminal value of any investment, while the percentual impact will increase with the investment duration.

The differences between single and ongoing charges

While on investor’s level transaction costs only become due on a trade within the portfolio, ongoing charges affect the investment continuously. Both types of costs are highly relevant for investors, with the investment horizon and the rebalancing frequency being the variables with the greatest influence (Xubinstein 1991).

If an investor wants to engage in capital markets via actively managed funds, he usually has to pay sales loads or bid-offer spreads in the rare occasion of exchange listed mutual funds. Those sales loads are usually front-end or deferred loads an investor has to pay when purchasing or selling a fund that aims to incentivize advisors and brokers facilitating sales or as exit barrier for the investors (Delva & Olson 1998).

Considering long term investments, you could argue that even a 5% front load is negligible for the terminal value. Due to the compound interest this is not the case, with significant effects on the profitability of any investment. However, ongoing charges are even more relevant because they affect returns over the whole investment period applying in both, bear and bull markets. That is even more the case the longer the investment horizon. Most actively managed funds exhibit multiple share classes that differ in ongoing charges and loads charged. Usually the smaller the sales loads, the higher the ongoing charges (Hortacsu & Syverson 2004).

To illustrate the long term effect of costs on investment portfolio, we created a customizable calculator which is accessible at www.insoro.com. Please note that actual returns might differ and costs might change in the future. Invested capital is at risk.

insoro cost calculator (www.insoro.com)

While it has been shown that low cost index investments are superior to actively managed funds on average, the question is how to invest in them. Since most indices are just mathematical constructs to measure the performance of a geographic region or industry, investors can only participate in indices via eligible vehicles. The most common types of index investing is a portfolio of the underlying stocks, passive mutual index funds, Exchange Traded Funds and Index Futures. To participate in an index via a portfolio of the respective indices’ stocks is a task nearly impossible for retail investors as due to daily random changes in the underlying companies market capitalizations would lead to an enormous amount of trading necessary to maintain the index’ weights. (Bogle 2007; Stein 2017)

Investor protection

The EU law Markets in Financial Instruments Directive (known as MIFID), was introduced in 2007 with the aims of increasing investor protection and overall investment transparency. Building on the first directive, MIFID II was designed to further increase investor protection by banning sales commissions for independent financial advisory. Unfortunately, the passage was changed to a non binding voluntary clause by the EU parliament. Countries like the UK and the Netherlands implemented a binding statute, while several countries did not follow those examples even though the directive would have saved a lot of investors money, which due to high management fees in high commission vehicles only benefited the issuing financial institutions. (MIFID 2018)

Since the updated versions of MIFID, MIFID II came into effect in early 2018 forcing banks and issuers to disclose nearly all costs that adhere to an investment. This led to enormous advantages for investors, enabling them to compare investment products and comprehend formerly obscure fee structures. (ESMA n.d.; MIFID 2018)

Conclusion

In efficient markets, costs are the most important selection criteria when considering investment opportunities. Follow our articles to learn which costs occur when engaging in capital markets and how modern technology can help you to decrease investment related cost and improve your returns.

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References

Bogle, J. C. (2007). “Enhanced” Index Funds: Can They Beat the Market? AAII Journal, 29(4), 13–16. Retrieved from http://search.ebscohost.com.pxz.iubh.de:8080/login.aspx?direct=true&db=bsu&AN=252067 07&site=ehost-live&scope=site

Delva, W. L., & Olson, G. T. (1998). The relationship between mutual fund fees and expenses and their effects on performance. The Financial Review, 33(1), 85–104. doi:https://doi.org/10.1111/j.1540- 6288.1998.tb01609.x

ESMA. (n.d.). MIFID II. Retrieved from https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir

Hortacsu, A., & Syverson, C. (2004). Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of the S&P 500 Index Funds. The Quarterly Journal of Economics, 119(2), 403–456. doi:https://doi.org/10.1162/0033553041382184

Marten, E. (2018) Here’s exactly what an index fund is — and why it’s Warren Buffett’s favorite way to invest. CNBC. Retrieved from https://www.cnbc.com/2018/04/24/why-an-index-fund-is-warren-buffetts- favorite-way-to-invest.html

MIFID (2018). The MIFID II Guide. Retrieved from https://www.handbook.fca.org.uk/handbook/M2G.pdf

Stein, C. (2017) Active vs. Passive Investing.Bloomberg. Retrieved from https://www.bloomberg.com/quicktake/active-vs-passive-investing

Xubinstein M. (1991) Continuously rebalanced investment strategies. The Journal of Portfolio Management 1991.18.1:78–81