When do fund fees drop so low that it’s not worth the hassle of switching to a cheaper fund?
Naturally that’s a personal decision. But there does come a point when sweating the difference between two cut-rate options has a vanishingly small impact on your future wealth.
That point arrives when the cost of a fund in pounds falls so low that even moving to a rival that’s half the price makes little material difference.
The numbers bear out this apparent heresy – and I say this as someone who had it drilled into them that investment costs were to be crushed like infidels on the wrong side of a holy war.
What’s the cost in raw cash money?
To see how the diminishing returns of fee-relief set in, we have to assess fund costs in cash terms, as opposed to comparing the relative difference in their ongoing charge figure (OCF) percentages.
For example, let’s compare the fate of £10,000 invested in three funds for 30 years. I assume each fund returns 8% a year before these fees:
- Fund A’s OCF is 0.05%
- Fund B charges 0.25%
- Fund C whacks its investors for 1.25% per year
Fund B is fives times cheaper than fund C.
Similarly, fund A is five times cheaper than fund B.
However switching from fund B to fund A matters much less to your final investment outcome than making the leap from fund C to fund B would.
The Final investment pot line in the table below shows this clearly:
| Fund | A | B | C |
| Fund OCF (%) | 0.05 | 0.25% | 1.25% |
| Fees paid year one (£) | 5 | 25 | 125 |
| Final investment pot (£) | 99,238 | 93,868 | 70,963 |
| Total fees paid (£) | 1,388 | 6,758 | 29,663 |
Your final pot is 32.3% bigger if you invest in fund B not fund C. That’s huge!
But your final pot is only 5.7% bigger if you invest in fund A instead of fund B. Not so huge.
That 5.7% extra is useful for sure. But it’s probably not worth Force-choking your fund manager like Darth Vader whenever a competitor undercuts them by a basis point.
The fund fee drag factor
Ultimately, it’s the high cost in pounds of fund C that exacts an extreme toll, relative to the 8% per year earning power of your investment.
For example, all three funds above earn £800 on the £10,000 invested in year one.
But the proportional amount of that return trousered by the fund managers is very different as the fees scale:
| Fund | A | B | C |
| Fees paid year one (£) | 5 | 25 | 125 |
| Fee deduction from £800 year one return (%) | 0.63 | 3.13 | 15.63 |
Fund C swipes nearly 16% of your return in year one! That clearly hurts, and so reducing that loss to just 3% by running into the arms of fund B is well worth it.
However jumping ship again to fund A is much less of a win as the charges rush towards zero.
That’s because it’s the absolute difference in pounds that we care about. Not, ultimately, whether one fund is half the price of the other.
Metaphorically-speaking, you might be incentivised to drive an extra mile down the road to save £10 on filling up your car. But you may not bother for a quid off. Especially if there are plenty of other ‘to dos’ in your life that are screaming for attention.
I guess that the point of indifference to savings is related to the gallingly minor happiness boosts we feel when spending on upgrades.
For instance, having a phone is a very useful thing. But buying a new phone with a slightly better screen resolution? Who cares?
The absolute difference is barely detectable.
Running the numbers
Next time you want to see what difference fund fees could make, you could try using an investment fee calculator like the one offered by Dinky Town.
Play around and you will find that:
- The lower your returns, the more fees matter.
- The longer your time horizon, the more fees matter.
- Fees matter less the more your outcome relies on future monthly contributions, as opposed to your current investment balance. That’s because negative compounding has less time to do its dirty work.
More mathematics
Do a breakeven analysis when selling an unsheltered fund exposes you to capital gains tax.
Transaction costs and time out of the market can also potentially swamp tiny savings. (That’s much less of a consideration if you’re just switching between ETFs with minimal spreads.)
Once index tracker fees shrink low enough, tracking difference and variations in underlying holdings may become more decisive factors when weighing up two alternatives.
Spot the difference
You can get a grip on tracking difference by plotting a fund against its comparison index using Trustnet’s multi-plot charting tool.
Our fund comparison post explains how to add the correct index to your chart. (See The impact of the index section of the article.)
Tracking difference is a useful gauge of management efficiency. It’s a positive sign if a fund provider’s trackers typically cling tightly to the index. That’s what we want, so sometimes I’ll check a sample of a provider’s products to help me decide if that’s something they’re good at.
By contrast, the future variation in returns caused by rival funds’ divergent holdings is a crapshoot. The difference can be wild in sectors like gold miners or commodities, or marginal in categories like global tracker funds.
Past returns may tell us that a particular index configuration is flawed, or it could just be that some component suffered a losing streak that might flip into a hot hand at anytime.
Sometimes, if you dig deep enough, you can uncover reasons to believe that certain indexes or products contain inherent weaknesses.
Vanguard LifeStrategy 100’s home bias counts against it so long as the US stock market reigns supreme over the UK’s, for example.
Meanwhile, synthetic S&P 500 ETFs consistently outperform their physical counterparts due to an in-built tax advantage.
A cost of doing business
Transaction costs are another factor to investigate if you want a fuller picture. They can be as large as the OCF in some markets.
However these fees tend to fluctuate a lot and are hard to pin down.
Hargreaves Lansdown is a good source to research transaction costs. Navigate to a fund’s web page on the Hargreaves’ site. Go to the Costs section and you’ll find transaction fees nestling in the Investment Charges dropdown menu.
Your mileage may vary
Costs do matter. The difference between a 0.25% and 1% OCF fund is significant. But the wealth leakage from a 0.25% fund versus cheaper models is much less of a biggie.
After all there’s only so much time in the day. Beyond a certain point, relentlessly chasing fee reductions is more Captain Ahab than Martin Lewis.
By all means keep optimising until you’ve had your fill.
But if you’re losing the will, then take heart. If you’re passively invested in a portfolio of low-cost index funds and ETFs then you’re already well ahead of the game.
Take it steady,
The Accumulator