Risk and return – the two are generally considered to be inseparable.

Want higher returns? You’ll need to take more risk. Want to reduce risk? You’ll have to accept lower returns. Simple enough.

But there may be ways to improve returns without taking on more risk. Don’t believe me? Let’s see how.

Investing efficiently

In a nutshell, it’s all about efficiency. This means reducing fees and costs. By reducing costs, investors can improve their net returns, without needing to take on additional risk.

These can be fixed fees like account keeping fees and brokerage fees, or they can be asset-based fees, charged as a percentage of your investment, such as management costs.

One often overlooked cost is called ‘cash drag’. This is the cost of leaving parts of your money uninvested – i.e. sitting in cash. Depending on where those funds are sitting, you could be earning zero interest, a low interest rate, or a savings account interest rate.

Some investors may choose to hold cash as a way to reduce portfolio volatility, provide flexibility, or cover living costs – this is not what we mean when we say cash drag. Cash drag occurs when you have money that you intend to invest but haven’t made those investments yet.

But surely this won’t make a big impact, I hear you say. Well, while a few dollars or one percent here or there might not seem like big costs, they can really add up over a long period. And when you account for the compounding of returns, the difference can be significant.

Crunching the numbers

Just how significant? Let’s look at some hypothetical scenarios for illustrative purposes.

For the purposes of these projections1, we’ll make the following assumptions:

• Investment timeframe: 40 years

• Investment return: 6% p.a.

• Monthly investment: $1,000

• Starting balance: $0

Scenario 1: Management costs…

Management costs, sometimes referred to as an MER (management expense ratio), are usually charged as a percentage of your total investment value – an asset-based fee.

Let’s compare the projected returns for a hypothetical active equity fund with a management cost of 1.00% p.a. to a low-fee broad market-based index ETF charging 0.04% p.a.[2] For the purposes of this example, let’s also assume the risk level associated with the active equity fund is not materially different from the broad market-based index ETF.

Over the course of 40 years, that 1.00% p.a. fee can make a significant impact on investment returns. Assuming the return is the same for both funds, the investor paying the higher fee ends up with $1,526,020, while the investor paying the lower fee ends up with $1,970,010. That’s $443,990, or 29% more! Of course, its important to remember management costs aren’t the only factor that impacts returns.

Scenario 2: Brokerage…

One of the most common direct costs that investors incur is brokerage. According to Canstar, the average brokerage cost in Australia in 2022 for a $1,000 trade was $14.67[3]. For simplicity’s sake, let’s round that up to a fixed cost of $15 per month. For this scenario, we’ll assume we’re paying 0.04% p.a. in management costs.

While the chart might not look quite as shocking as the first scenario, we have ending balances of $1,940,460 and $1,970,010. So the investor paying $15 per month in brokerage is $29,550 worse off than the investor who paid no brokerage.

Scenario 3: Cash drag…

Here’s where it gets really interesting. Let’s consider a situation where, instead of investing $1,000 each month, we save up our cash over the course of a year, earning zero interest, and invest it all at the end of the year.

For the sake of simplicity, we’ll keep all other assumptions the same, and run with the $0 brokerage and 0.04% p.a. management cost. We’ll also assume that we receive no interest on their cash.

We’re comparing this making monthly investments – all other assumptions are the same. Surely, that can’t make a significant difference, right?

The annual investor ends up with $1,838,577 at the end of year 40, while the monthly investor ends up with $1,970,010. Investing monthly resulted in a balance that was $131,433, or 7.1% higher.

Another source of cash drag can be residuals left over from needing to purchase whole units in an ETF, or whole shares. For example, if you had $1,000 to invest, but wanted to buy an ETF with a price of $105, you’d be left with $55 sitting in cash. This can happen when making investments, or due to participation in distribution reinvestment programs (DRPs).

Scenario 4: Compounding on compounding…

Finally, let’s see what happens when we add all these effects together. Our ‘inefficient investor’ will pay both fees discussed above – $15 per month (which for simplicity we will refer to as an ‘account keeping fee’ in this example) and a management cost of 1.00% p.a. – plus they’ll make annual contributions to their investment (rather than doing so monthly).

We’ll compare this to an ‘efficient investor’ paying no monthly ‘account keeping fee’, a 0.04% p.a. management cost in relation to their investment and making monthly contributions to their investment.

The difference here is hard to ignore. The inefficient investor ends up with $1,427,853, while the efficient investor ends up with $1,970,010 – an extra $542,157, or 38%. And all we did was save money on account-keeping fees and management costs, as well as investing more regularly.

Efficiency in practice

While the above scenarios are hypothetical, it is possible to invest with lower management costs, no brokerage fees, and no account keeping fees. And with no brokerage fees, it’s easy and frictionless to invest as often as your situation allows.

Betashares recently launched our new investing platform, Betashares Direct, which allows investors to buy ETFs traded on Australian exchanges with zero brokerage and no account fees. Betashares Direct also offers fractional investments in ETFs, helping to reduce residual cash holdings and increase efficiency, as well as an AutoPilot feature that allows you to set up automated, recurring investments.

And with a broad range of low cost ETFs available on the ASX, it’s easy to keep costs low when building a diversified portfolio.

Written by Patrick Poke for Betashares.

Refer to the Product Disclosure Statement for information on interest retained by Betashares on cash balances and portfolio fees associated with AutoPilot portfolios.

References:
1. All projections in this article are in nominal and not real terms, i.e. they have not been increased to account for inflation.
2. Based on the management cost for Betashares Australia 200 ETF (ASX: A200).
3. Source: Canstar. Brokerage fees Australia: What is a brokerage fee?

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Betashares Capital Limited (ABN 78 139 566 868 AFSL 341181) (Betashares) is the responsible entity and issuer of the Betashares Funds.

Before making an investment decision, read the relevant Product Disclosure Statement, available from this website (www.betashares.com.au) or by calling 1300 487 577, and consider whether the product is right for you. You may also wish to consider the relevant Target Market Determination, which sets out the class of consumers that comprise the target market for the Betashares Fund and is available at www.betashares.com.au/target-market-determinations.

This information is general in nature and doesn’t take into account any person’s financial objectives, situation or needs. You should consider its appropriateness taking into account such factors and seek professional financial advice.

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