One lesson we should all learn from the Americans

published 29 April 2013

Pity the poor American fund manager.

He's feeling the pinch. US investors are paying less and less for his services.

Last year, the average American investor paid just 0.77% in annual expenses for buying an equity fund, according to data from fund research group Lipper. That's just $0.77 for every $100 invested.

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Twenty years ago, they were paying $1.07 for every $100 invested. That's a huge improvement.

It's also a shocking statistic. Not because of what it means for the standard of living of US fund managers.

But because of just how far behind the American we are on this side of the Atlantic

Spot the difference our fund costs are massive compared to the US

US investors are cottoning on to the fact that costs really matter, as the FT's fund management supplement notes this morning.

Annual fees paid by US investors have slid to well below 1% over the past two decades.

But what's really shocking about the piece is just how much more we're paying over here. "Current expense ratios [ie annual costs] for European equity large-cap and mid to small-cap funds hover at 171 basis points."

In other words, we're paying the equivalent of $1.71 per $100 we invest in stocks. That's more than double what our US counterparts are paying today - and still about two-thirds more than they were paying 20 years ago!

Why the big difference?

One of the big reasons is that passive' funds have been promoted harder for longer in the US. Passive funds merely track an underlying index or asset price. Active' funds try to beat an underlying index.

You might think: why buy passive? I'd rather beat the market.

Nice idea in theory. The problem with active funds is that very few consistently beat the underlying index. They are also a lot more expensive than passive funds. So you end up underperforming the market, and you then have to pay extra fees on top. That all takes its toll on your pension pot at the end of the day.

So it's far better to just track the performance of the market each year, and make sure you pay as little as possible to do it.

One of the biggest proponents of passive investing has been the US low-cost tracker group Vanguard. The company's Frank Kinniry tells the FT: "Costs are now a primary decision for all investors. Their mentality has changed."

It also helps that more investors pay for advice upfront in the US. When they are paying their advisor, they don't expect to have to pay a lot again on top of that for management costs too.

So when can we expect this low-cost nirvana to take hold over here too?

Costs will fall here too but you don't have to wait for it to happen

In the longer run, you would expect the UK to follow the US.

Prior to the start of this year, actively managed funds had an unfair advantage over most passive funds. The majority of fund sales came via independent financial advisors (IFAs). IFAs in turn were paid commission by the companies running the actively managed funds.

So, oddly enough, IFAs had a tendency to favour actively managed funds.

But commission payments have now been banned (under the Retail Distribution Review RDR). This means that IFAs should now be choosing products solely on the basis of how suitable they are for their clients. Any sensible IFA will understand that costs are one of the biggest factors impacting on performance over the long run.

Meanwhile, you'll also get more investors choosing to manage their own money rather than pay an IFA. Any investor with the gumption to run their own money is also very likely to quickly realise the impact of costs on their portfolio, if they haven't already.

So the key advantage that these over-priced active managers once had, is now gone. Investors are paying more and more attention to the price tag on the financial products they buy. That will put pressure on the whole industry to cut costs, or to justify higher prices by producing genuinely innovative products.

The day of the closet tracker', which hugs the FTSE All-Share while charging near-enough 2% in fees for the privilege, is coming to an end.

All of this will take time in coming, of course. And many companies would rather gamble on maintaining the status quo through investor apathy and clever branding, rather than make changes. You can see why. It's never nice when a gravy train rolls to a halt.

The good news is that you don't have to wait for the industry to catch up. There are plenty of low-priced funds out there already that will do just as good, if not a better job, of growing your money. From exchange-traded funds to cheap index-tracking unit trusts, there has never been more choice out there for the do-it-yourself' investor.

My colleague Phil Oakley has been working on a project that allows you to take charge of your own portfolio and build up a potentially huge nest-egg, while slashing costs to the bare minimum. You can read more about Phil's strategy here.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.