Focus on what matters - Part 1

Focus on what you get to keep

There's a lot of attention paid to fund management fees, with both regulatory and competitive pressure to keep fees low.  The implication is that lower fees will result in higher returns to investors, but fees are just one of the inputs in determining the returns you will receive as an investor.  

What really matters isn’t fees but net returns after tax – because that’s what you, the investor, get to keep. In particular what matters is net returns after tax over medium- to long-term horizons. Any fund manager (even us!) can fluke one good year, so you should focus on their average net returns after tax across two year, three year and five year periods.

Fees are only one input

It seems the accepted wisdom is that the only difference between competing funds is their level of fees, and so lower fees will result in higher returns to investors.

That may be true within directly comparable passively managed funds – if you have two competing NZX50 index tracking funds then yes the difference between their fees will be important.  But other than that narrow situation the other differences between funds will overwhelm the relatively small differences in fees.

Base fees can range from as low as 0.1% pa for large passively-managed funds through to as much as 1.5% pa for some actively-managed equity funds, but most funds have base fees in the range of 0.6% to 1.1% pa.  So the difference in base fees between two ostensibly comparable funds is likely no more than 0.5% pa.

But the difference in gross returns between funds, even within the same asset class, can be much higher than 0.5% pa.  MJW’s excellent quarterly investment surveys show you the gross returns, before tax, for about 200 investment funds and for all the KiwiSaver providers.  Their most recent survey, for the March 2021 quarter, shows variability in 5 year gross returns of:

Pragmatically, the differences in gross returns due to differing fund manager styles, strategies and execution will almost certainly outweigh any small differences in their fees.  Basing your choice of a global equity fund on a 0.5% pa differences in base fees seems mis-directed when there’s a 13.0% pa difference in gross returns between the best and worst managers.  Our grandparents generation used to call that being “penny wise, pound foolish”.

Added to which there can be material differences in the effective tax rates between funds too, as different portfolio compositions lead to different levels of taxable income.  A 28% PIR investor may easily find that the difference in the tax they would pay on two apparently comparable funds can equate to more than 1% pa.

Comparing only fees is appealing because it’s simple, but a focus only on lowest fees won’t capture these other factors.  But the differences in gross performance, in fees and in tax are captured when you compare funds on the basis of their net returns after tax.  

There’s both risk and return

Yes, when you’re evaluating a fund it is important to weigh the net returns after tax against risk.  We recognise judging returns against risk is hard, especially given the limited information investors can access.  We’ve written a little about risk already, and will write more about how we measure and weigh risk.

But, as a general guide, funds within the same asset class (for example, all New Zealand equity funds) will tend to have broadly the same investment risk profile.  They may have different weightings to individual stocks or sectors, but an adverse event in any one stock should be softened by the fund’s diversification while the significant events (for example the 2008 Global Financial Crisis) will tend to affect an entire market and impact all funds in that asset class to a similar degree.