You get what you pay for. Or do you?

Actually, when it comes to investing, it’s what you don’t pay for that can help to make the difference. Keeping costs low and maximising your tax advantages provides the best chance of a successful investment experience. Otherwise, you can create a major drain on your investment performance.

Dr Paul Woolley from the London School of Economics said, in a recent Panorama program, that while fund management fees had doubled for pension plan investors over the last 10 years, net returns had reduced by the amount that fees had gone up.

It’s not just pensions

When the Financial Research Corporation, an independent research company, looked at the 10 characteristics differentiating mutual funds, it found expense ratios to be the only factor to be reliably linked to net performance. (Source: Vanguard)

Another research company, Morningstar, a worldwide fund rating company, monitored five broad categories of equity and fixed income funds from 2005 to 2010. The performance of the cheapest funds was compared to that of the most expensive. The cheap funds outperformed and they found that cost was a more reliable indicator of future performance than their own “star” fund rating system.

We accept this is short term data but the details of a longer term survey of Actively Managed mutual funds in the US was provided by Dr Burton Malkiel, author of a Random Walk Down Wall Street. This survey looked at all general equity mutual funds in the US from 31.12.1994-31.12.2009 and showed that the funds in the lowest quartile of costs and trading activity achieved 8.66% return and the highest Quartile of costs and trading achieved 6.66% return (Source: Lipper data for all General Funds).

As Jack Bogle, founder of Vanguard, one of the world’s largest investment management companies says:

“The only element of fund performance of which we can be absolutely certain, in advance, is fees. This means that the most important element in fund selection is cost.”

How do you keep the costs of investing low?

We do this by adopting a ‘passive’ approach to investing. Passive investing means buying a commercially or individually defined index of investments in order to get the market return in the long term, rather than trying to forecast potential short-term returns. Re-balancing keeps the exposure to risk consistent and ensures the valuable discipline of selling high and buying low the opposite to what your emotions want to do.

There are two main investment strategies within this passive approach:

Indexing: an investment strategy that seeks to provide returns closely linked to an underlying benchmark Index after charges

Asset Class or Smart Indexing: an investment strategy that seeks to determine which assets classes are worth holding for the long term based on academic evidence gathered over the last fifty years. These assets are then purchased in the most efficient and diverse manner making it highly likely that the returns on the chosen asset classes are achieved without undue trading costs or stock specific risk.

The case for Indexing

Index Managers believe share and bond markets are efficient and price shares and fixed interest fairly.

They allow commercial benchmarks to define investment strategy, which in practice means that the market knows what and when they need to buy and sell and sets prices accordingly.

Annual management costs are typically very low ranging from 0.1%-1% depending on the index being tracked and whether you achieve institutional pricing or retail pricing. Much lower trading costs are also achieved compared to those incurred by active investment managers due to the constant reading of stock in an attempt to find winners.

The case for Asset Class or Smart Indexing

Asset Class Managers believe share and bond markets work and price shares and fixed interest fairly.

They capture specific dimensions of risk defined by financial science – such as small and value shares, and increase the expected return through portfolio design and reduced trading costs.

Asset Class Managers are not forced to buy or sell any stock by the decisions of an Index Committee, which is a significant advantage. This means they tend to underpay for shares and achieve better prices when selling.

Annual management costs are typically very low ranging from 0.25%-0.75% depending on the asset class being tracked with emerging markets and global small value companies being the most expensive to invest in.

Lower trading costs are also achieved due to the low portfolio turnover and patience adding value over time.

BpH investment beliefs

We believe in what the last five decades of academic research tells us. You can’t beat the market in the long term so you shouldn’t try. This is why we recommend a diversified passive, patient, long term approach to your investments whilst protecting yourself from unnecessary costs.

It is better to invest in the whole market, not in today’s best performing part.

A focus on costs is just one of the secrets of good investment.

To discover a few more we recommend that you take 5 minutes to look at the following site where there are some interesting ‘table top’ guides.