Investors are voting with their feet on costs
12 September 2019 | Markets and Economy
In many areas of life, the more you pay for something, the better the product you expect to get. But in investing, there’s no reason to assume that you get more if you pay more. The more you pay in management fees or trading commissions, the less there is earning a potential return.
In contrast with the unpredictable returns from financial markets, cost is one aspect investors can control. And it seems increasing numbers of them are focusing on what they pay to invest, allowing them to keep a greater share of investment returns.
New Vanguard research has shed light on the extent to which investors in the US are migrating from high-cost investments to lower-cost funds, and the findings could hint at what’s in store for the industry in Europe.
The shift to low cost
The new Vanguard Research Insight highlights a clear trend that is emerging in the US as investors increasingly vote with their feet on investment costs. In a stark message to the industry, net cash flows going back more than a decade demonstrate how more and more investors are taking control of how much they pay asset managers.
The research shows that, over the past 15 years, investors have displayed a striking preference for low-cost funds over high-cost funds.
Among US equity funds and ETFs, those with the lowest-quartile expense ratios garnered around $1.25 trillion in assets between 2003 and 2018 (see chart 1). This is in marked contrast with the three quartiles of funds with higher expense ratios, which all experienced negative cash flows during the same period.
Chart 1: Relationship between net cash flow and expense-ratio quartile of U.S. equity and fixed income funds and ETFs
Notes: Expense-ratio quartiles were calculated annually. Equity funds are represented by Morningstar U.S. equity category. Each quartile represents 2018 asset-weighted average expense ratios, determined by multiplying annual expense ratios by year-end assets under management and dividing by the aggregate assets in each quartile. Data are as of December 31, 2018. Source: Vanguard.
Notes: Expense-ratio quartiles were calculated annually. Fixed income funds are represented by Morningstar Investment-grade U.S. fixed income categories. Each quartile represents 2018 asset-weighted average expense ratios, determined by multiplying annual expense ratios by year-end assets under management and dividing by the aggregate assets in each quartile. Data are as of December 31, 2018. Source: Vanguard.
The lowest-cost quartile of funds had a median expense ratio of 0.21%, while the higher-cost second, third and fourth quartiles had median expense ratios of 0.72%, 0.95% and 1.49% respectively.
A similar trend is evident in bonds, where nearly all net cash flows into taxable bond funds over the 15-year period went into lower-cost options.
US bond funds and ETFs with the lowest-quartile expense ratios received around $1.48 trillion of inflows. This was some way ahead of the second-lowest cost quartile of funds, which gathered just $110 billion of inflows, while the two quartiles of funds with higher expense ratios suffered net outflows.
Here, median expense ratios ranged from 0.14% for the lowest-cost quartile of bond funds through to 0.45%, 0.63% and 1.07% for the second, third and fourth quartiles respectively.
Why the exodus to low-cost funds? It all comes down to returns.
Keeping more of the returns
The research also revealed the disparity in investment performance between the lowest- and highest-cost funds. Over the ten years ending December 31, 2018, low-cost funds outperformed high-cost funds across every category of equity and bond funds analysed (see chart 2).
Chart 2: Difference in ten-year annualized return between median funds in lowest- and highest-cost quartiles
Note: Data are as of December 31, 2018. Source: Vanguard.
The message is clear. Investors in low-cost funds are keeping more of what they pay for, and it highlights why fees represent such a crucial consideration in fund selection.
High cost is among the biggest enemies of successful investing. A significant body of research suggests that not only is high cost a major impediment to success, but low cost is actually the best predictor of future outperformance1.
It is especially vital that investors control costs over the long term. Just like returns, the impact of costs compounds over time, slowing investors’ progress towards their goals. And the importance of cost to investment outcomes applies to all funds, no matter whether they are actively managed or indexed.
Cost-consciousness in Europe
This shift to low-cost funds by US investors has potential lessons for the industry in Europe.
European investors are also becoming increasingly cost-conscious. New regulations with a greater emphasis on fees, such as Mifid II and the UK Retail Distribution Review (RDR), are accelerating the move towards lower-cost options. The rising use of online cost and performance comparison tools is also giving investors a clearer understanding of the impact that high costs can have on investment returns.
The emergence of exchange-traded funds (ETFs) is raising awareness of costs, too. As an investment vehicle that mainly focuses on indexed strategies, ETFs have allowed investors to gain simple, low-cost access to a range of markets.
1 See for example Financial Research Corporation (2002), Morningstar (Kinnel, 2010), James J. Rowley Jr., CFA; David J. Walker, CFA; Carol Zhu, 2019. The case for low-cost index-fund investing. Valley Forge, Pa.: The Vanguard Group.
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