Enhancing portfolio performance

Effective cost management is critical for improving personal investments. Make sure you consider all the factors

By Ross McShane

Effective cost management is an integral component of a successful personal investment strategy. As with any business, the ultimate goal of cost management is to optimize performance to enhance returns.   

In personal investment management, the focus of cost management is typically on lower fees, which can have a significant positive impact on long-term portfolio returns. When combined with disciplined financial and tax planning, rigorous investment selection, diligent portfolio monitoring and evaluation, and prudent, unbiased advice, the end result of effective cost management is improved financial results for the investor. 

Know what you’re paying

In Canada, the downward pressure on fees in the investment industry has become more pronounced in recent years. However, there remains a wide divergence in fees among different products and companies, accompanied by a lack of transparency and clarity in disclosure.

As a result, a significant portion of investors either end up paying above-average fees or are uncertain of how much they pay in fees. According to the results of a survey of 376 Canadian investors between the ages of 25 and 64 conducted by Decima Research on behalf of Stratos Wealth Management in August 2005, 48% of investors believed that they were paying too much in fees; 40% were comfortable with what they pay; and 12% didn’t know whether or not they were paying too much in fees.

Of the survey respondents who knew what they were paying, 43% were paying 3% or more of their total portfolio investment in fees, while 6% claim they are paying more than 10%. A comparison of the survey results to the average management expense ratio (MER) in Canada, which according to Investor Economics was 2.04% for all funds in 2005, clearly indicates the need for cost control among those who are paying above average fees. 

Fee spreads

The total fees typically associated with investment products may include sales commissions, deferred sales charges, and management, operating and administrative expenses. Some products, such as wrap accounts and fund of fund accounts, may have duplicated fees — a fee on the underlying investments as well as a fee on total assets held in a portfolio. On the other hand, balanced fund investors may end up paying equity-linked fees on the fixed income portion of the funds’ assets, or some investors may hold segregated funds that have high management expense ratios for the benefit of unnecessary principal protection.

Fees typically vary by fund type, with equity funds averaging 2.28%, bond funds 1.45%, and balanced funds 2.12%, based on Investor Economics research for 2005. Although the differential in fees among different fund families may appear modest, investors often overlook the compounding effect of fees on total returns over the long term. A MER reduction of 1% on a portfolio of $200,000, for instance, can amount to a cost saving of $2,000 each year. After 25 years, this saving can result in an increase in the total value of a client’s portfolio of more than $146,200, based on a compounded annual return of 8%. Therefore, it is prudent to weigh both performance and fees equally when selecting funds.

Arguably, neither low nor high fees can be correlated with performance. Put simply, low fees don’t guarantee better returns, whereas high fees don’t automatically signal worse returns. Nonetheless, given uncertainty in performance results, selecting high-quality, low-cost investments is obviously the most effective cost management strategy an investor can aim for. Costs are more predictable and manageable than performance, which means that there is a greater potential benefit for investors over the long term.

The bottom line

In as much as managing fee expense is a critical determinant of enhanced performance, the bottom line results for an investor are inextricably linked to a comprehensive process that facilitates implementation, execution and maintenance of a complete personal investment strategy.

This process includes, among other strategies, the implementation of tax-efficient asset allocation strategies; income splitting to lower taxes payable; the use of spousal RRSPs and pension income to balance retirement income and reduce taxes; implementation of debt and cash management strategies to save on interest costs; and reduction of administrative expenses through account/service consolidation.

At the end of the day, the bottom line goal is to enhance portfolio returns as well as leverage the gains made through a variety of cost reduction strategies. However, the successful implementation of any cost management requires the use of an unbiased service provider that is focused on enhancing returns by using a proven process that incorporates transparent, competitive pricing; choice in service levels; high-quality, customized  portfolios and unbiased, professional advice.

If you are interested in exploring some of the cost management concepts discussed in this article you should seek the advice of a qualified, unbiased financial planner, who should be able to provide, among other services, a comparative analysis of the direct and indirect costs within your portfolio.

Ross McShane (ross.mcshane@stratoswealth.com) is a senior financial consultant with Stratos Wealth Management, a division of MD Management.

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