But one aspect about future return is known, and that is the extent to which it will be reduced by fees. Investors can improve their return by 1% pa (or more), simply by paying 1% pa less in fees.
In the absence of any real negotiating power with service providers this requires investors to make a choice: either go for the traditional high-touch model based on brokers and fund managers, or a low-touch model relying on automated advice and index funds.
The underlying fee differential provides the proper context to evaluate these two approaches. The ‘active versus passive’ debate tends to get bogged down in emotional and theoretical arguments when, ultimately, the most important point is: Which fee structure is more likely to secure an adequate return for retirement savers?
As a long-term investor you should focus on what is probable rather than what is possible. Yes, you can beat the market averages with an active strategy, but probably, you won’t. The risk is that you do much worse, and miss your savings goal, to retire in relative comfort.
With an active approach, it doesn’t take much to do a lot worse. And whereas you may have gotten away with sub-optimal returns in the past, you may not do so in future.
To explain why, the table below summarises the typical pay-off for high-touch and low-touch investors in the share market. Both groups earn the same long-term real (after-inflation) return of 7%. The former pays an all-in-cost of 2% pa, the latter 0.75% pa.
This means that low-touch investors take home 6,25%, but high-touch investors only 5%. Collectively, they have already lost, simply by paying higher fees.
Fig 1: High-touch versus low-touch: probable equity returns
That’s just the tip of the iceberg, though. Empirically, as an active investor you have roughly a 20% chance of earning an above-average return (say 9%) over the long term. But that comes with a catch: the more the ‘winners’ take, the less the ‘losers’ get. To reconcile back to the average market return of 7%, the remaining 80% of the active group can earn only 6,5%.
Net of fees, the ‘winners’ get 7% (0,75% more than ‘passive’ investors). The ‘losers’ earn 4,5% (1,75% less than ‘passive’ investors).
You’ll notice that the pay-off profile in this gamble is highly skewed. The upside reward (0,75%) is lower than the downside loss (1,75%). And the chance of losing is four times higher than the chance of winning. No self-respecting gambler would take this bet, yet it’s the standard active investment model.
This pay-off profile should alert any retirement saver pursuing a minimum goal, say a final income replacement ratio of 60%. This goal is easily achievable if you save 15% of your income for 40 years, and you earn a net real return of at least 3% pa.
The long-term gross return on a Regulation 28-compliant balanced high (75%) equity portfolio has historically been around 6% pa.
Assuming the same fees as before, a low-touch investor could expect a net return of 5.25%, presenting a considerable margin of safety. While the active group still earned 4%, 80% would receive only 3,5% on average, barely above the required rate of return.
Fig 2: High-touch v low-touch: historical balanced portfolio returns (7% equity return)
Of course, the ‘average, historical’ market return is not guaranteed. Based on 100-year data there’s a one-in-five chance that the 40-year ‘real’ equity market return will be as low as 4,5% pa.
We could be facing one of those times. For a myriad of structural and economic reasons, the prospect that future equity returns will be lower than before is very real. Many market commentators expect no more than 4%, but let’s assume it’s 5%. All else equal, this would depress the overall return of our high-equity portfolio to 4,5% pa.
Fig 3: High-touch v low-touch: probable balanced portfolio returns (5% equity return)
Earning 4,5% pa before fees would still suffice for low-touch investors; however, the average high-touch return drops to 2,5% pa; 80% stand to earn just 2%.
By paying high fees in a low return environment, the great majority of ‘active’ investors have virtually no chance of getting anywhere near a comfortable retirement, unless they up their savings rate considerably.
Given these probabilities, which is the rational approach? Is it the one that gives you (saving at the required rate for the required time) a high chance of meeting your goal, with a margin of error? Or is the one that is likely to succeed only 20% of the time, but will badly ‘fail’ the majority of investors?
Ultimately, it is in this context – high cost versus low cost, probable outcomes versus possible outcomes – that we should hold the ‘active versus passive’ debate. And here, too, we find that there is not much room for debate. The numbers and the probability-adjusted outcomes speak for themselves.
