Investors Should Focus on Outcomes Not Just Fees

Low-cost investing is extremely important, and recent no-fee fund developments should be celebrated. However, it is not a risk-free proposition

Emma Morgan 22 August, 2018 | 8:23AM
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Assets in passive funds continue to rise at astounding rates with no signs of abating. This trend has received another boost, with Fidelity the first product provider to offer free “core” offerings to U.S. investors, with two investments that provide broad access to the local and international equity markets.

This has aroused widespread feedback, with everything from cynicism to applause. We have a rather pragmatic view of the matter and hope to shed light by relating it to the future plight of a multi-asset investor. Along the way, we’ll continually circle back to what is most important: asking whether the developments help investors to reach their financial goals.

Dilemma 1: Remembering the Goal

One should not underestimate the psychological shift the recent developments may have. With no fees and no minimum investments, this development could usher in a new era of investing. In this sense, it is difficult to see such developments as anything but positive, although we would temper the blind enthusiasm by encouraging investors to think about what they are trying to achieve.

Lower fees are a great development for investors

For multi-asset investors, the focus must be on the goal—whether that be saving for retirement, achieving financial security, or maximising net-of-fee returns. These are all delicately different from investing as cheaply as possible. For example, one concern that stems from this move is that retail investors may be inclined to allocate a higher portion of their portfolio to the zero-fee products without considering what that means for the portfolio composition.

If building portfolios holistically is the ambition—which we believe it should be—we should devote a proportionate amount of our attention to fees, without letting it completely dominate the investment decision.

Dilemma 2: Knowing What You are Getting

The initial wave of excitement is likely to generate positive flows into zero-fee providers, although we’d encourage investors to think carefully about the assets they are buying. For instance, a North America index fund will be different from a U.S. index fund, which will be different again from an index fund that follows, say, the Standard and Poor’s 500. The more illiquid the asset class, the closer an eye will be required too, so understanding the benchmarking of these providers will be an important consideration.

Furthermore, it will also be important to think about the compounding benefit received. For instance, if you compare an asset that charges no fee to one that charges 1% or more, the compounding drag is enormous. Yet, if you compare a zero-fee product to one that charges 0.07%, the impact is actually quite small. It may be worth more than a few basis points to know what you are getting.

The compounding impact of fees must be considered

Dilemma 3: It is Not a Risk-free Proposition

As investors, we should be clear on the motives or incentives behind any such cuts in fees. First, it is worth reflecting that there is rarely such a thing as a free lunch. While some providers may contemplate such a move as a loss leader, the more plausible incentive is that passive funds continue to make money from securities lending.

As you can likely imagine, zero-fee investing is not a risk-free proposition. While the risks inherent in security lending seem low, they could be exposed in times of market stress. For example, in the peak of a crisis, when investors want liquidity, providers may have difficulty unwinding their lending activity.

What Does This Mean for Multi-Asset Investors?

While pundits speculate about the domino-effect of zero-fee fund launches, we remain focused on delivering outcomes that will help investors reach their goals.

For multi-asset investors, this requires a pragmatic view of recent developments. Like many others, we are cheering on the so-called race to the bottom. The lower fees go, the easier it is—all else equal—to reach investor goals. However, we must be equally aware of the challenges it may present and construct our portfolios using the best available tools for the job.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Morgan  is a Portfolio Manager for Morningstar Investment Management EMEA

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