'You get what you don't pay for'
01 October 2016 | Investment principles
More than a decade ago in Orlando Florida, Vanguard founder John Bogle gave a keynote address with the intriguing title: "In Investing, you get what you don't pay for".
His fundamental argument – a play on the adage "you get what you pay for" – was that high investment costs erode rather than enhance net investment returns.
Vanguard has subsequently issued and updated research papers headed: Shopping for alpha: You get what you don't pay for. Based on detailed long-term returns of actively-managed investment funds, the papers have concluded and confirmed that cost is the "most significant indicator" of future, risk-adjusted returns or alpha.
As the latest of these papers states: "But this conclusion may seem paradoxical since it's inconsistent with the typical relationship between price and quality. Consumers generally assume that if they pay more for something, they will get better quality in return."
And the authors of an earlier version of the paper colourfully reinforced this point with the comment: "When you get behind the wheel, there's no mistaking a Yugo for a Bentley". (A Yugo, by the way, is an extremely modest vehicle rarely seen on Australian roads.) However, investors who choose high-cost investment funds in the expectation of above-market returns are likely to face disappointment.
Research of past returns has found over and over again that most higher-fee, actively-managed funds have struggled to beat or at least equal the market over the short, medium and long term once their fees are taken into account.
For instance, figures gathered by investment researcher Morningstar in Australia – show that on an after-fee basis:
- Only 182 (or 36.2 per cent) of 502 actively-managed, large-cap Australian share funds did as well or outperformed the S&P/ASX 200 Accumulation Index over the 12 months to August 31.
- 178 (or 37.16 per cent) of 479 actively-managed, large-cap Australian share funds did as well or outperformed the S&P/ASX 200 Accumulation Index over the three years to August 31.
- 161 (or 35.69 per cent) of 451 actively-managed, large-cap Australian share funds did as well or outperformed the S&P/ASX 200 Accumulation Index over the five years to August 31.
- 116 (or 36.47 per cent) of 318 actively-managed, large-cap Australian share funds did as well or outperformed the S&P/ASX 200 Accumulation Index over the ten years to August 31.
It is worth emphasising that Morningstar measured the funds' returns in after-fee terms.
Many investors who recognise the case for low-cost index-tracking funds nevertheless include actively-managed funds and direct investments in their portfolios.
Such investors often adopt a core-satellite approach, investing the core of their portfolios in index funds while holding smaller satellites of favoured actively-managed funds and direct investments.
Unfortunately, discussions about index funds and actively-managed funds are frequently conducted as an "either-or" debate.
While Vanguard, for instance, is best known in Australia for its traditional index funds and ETFs, approximately a third of the assets that it manages globally are in actively-managed funds.
Whether investing in actively-managed funds, index-tracking funds or a combination of both, investors can improve their opportunities for investment success by minimising their costs.
Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
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Robin Bowerman, Principal, Market Strategy & Communications at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.