Future Focus: The three factors that will increase your returns
Perfect your portfolio to put yourself in the best position to maximise your returns.
I have been thinking about how investors maximise returns. Not about how to find the best investments – but how to maximise the returns of the ones that you have.
You can have stringent standards and a quality process for finding investments, but a large part of success for an investor are factors that are peripheral to the investments that you hold. I’ve written before about how I focus on what I can control – my behaviour and trying to keep fees low and taxes minimised.
This approach has been formed through a few insights, but mainly from a quantitative look at the contributors and detractors to total return. That is – the return that you get in your bank account at the end of the day, once fees, taxes and transaction costs are paid.
We are all looking for investments which suit our individual goals and time horizons. This exercise is looking at the other factors you can apply to ensure you increase the likelihood of meeting your financial goals.
Low fees
This factor feels intuitive, but it’s easy to get complacent. Morningstar research shows the power of low fees. Our research has found that a fund’s annual fee is the most proven predictor of future fund returns.
Morningstar’s study split fund share classes into fee quintiles by style factors for equity funds and geography for bond funds. Our analysts looked at the relationship between the average total returns and average fees across the quintilesfor the five years ended June 2024. For each quintile a success ratio was calculated, which indicates the percentage of share classes that survived and outperformed their Morningstar Category peers.
Across most categories that were examined as part of this study, the cheapest quintile achieved a higher success ratio than the most expensive fee quintile. This illustrates the destructive factor fees have on returns.
As an example, in the global large-cap equity group, the cheapest quintile recorded a success ratio of 60%, while the priciest option recorded 23%. A similar trend was seen in the Australian large-cap equity group (55% versus 20%). The categories contained a significant number of passive funds in the cheapest quintile.
Fees are pivotal to the success of your investment.
When I first started investing, I was playing around with financial calculators to understand how long it would take me to build wealth with the amount I was saving. This is an exercise where you are focused on the variables that impacted returns. Moneysmart (a government website) has a great calculator that provides a visualisation of your total return along with the impact of fees.
Imagine a scenario in which you have $100,000 invested and contribute $1,000 a month. You earn a 7% p.a. over 20 years. Below, you can see what your account balance will look like, depending on your fund’s fee levels.
The fee does not proportionately decrease the return. This is reverse compounding as wealth generation accelerates with each reduction in fees. It shows why Morningstar’s research has concluded that being in the lowest fee quartile improved performance.
If you are investing in individual shares, you don’t have to worry about fees, but you do need to worry about transaction costs. The same principle applies – you want to ensure that you control your costs. Any costs taken from your investment lose the ability to compound.
Low taxes
There are a few considerations for minimising taxes:
- Structure: What is the structure where you will be in the lowest effective tax rate? I’ve written about the different structures including individual, corporate or trust. However, for most income earners in Australia, the lowest tax rate will be in superannuation.
- Look at the turnover of the investment: This is important if you are investing in managed funds, ETFs, or any professionally managed account. Turnover simply means how much of the portfolio is bought and sold each year. A high turnover portfolio often means that you will have a higher tax bill. If you only own individual shares, it is important to reflect on the overall turnover rate of your own portfolio. Are you buying and selling frequently? Is the frequency of your portfolio rebalancing adequate?
- Franking credits: Franking credits is a tax rebate. Owning investments with franking credits will reduce your tax liability on the income tax owed on the investment.
Behaviour
I wrote about the largest determinant of returns recently. It is your own behaviour.
Poor behaviour has a large impact on your total return outcomes. Market returns are going to be out of your control. To a large extent, the taxes that you pay and the transaction costs that you incur are inevitable. Although, they can be limited through smart choices. Your behaviour is entirely within your control.
Morningstar’s Mind the Gap study shows that investors realised a return of 6.3% a year over a decade to 31st December 2023. The investments they purchased and sold had a total return of 7.3%. This is a gap of 1.1% a year, or about 15% of the total return that is lost by poor behaviour.
This is purely because of decisions that investors have made to enter and exit funds at certain times.
Investors are not perfect. There will be times where you deviate from your plan or make poor decisions. However, having a clear strategy and being transparent with yourself will mean that you can limit this behaviour. This includes reflecting on past behaviour and understanding the decisions and conditions that make you susceptible to deviating from your plan. Ensure that you have an airtight Investment Policy Statement (IPS) that will guide your decision making.
It’s easy to pay lip service to being a good investor and forget how important behaviour is to your total return outcomes. Before I started working at Morningstar, I focused on investing in direct equities and managed funds that I thought would beat the market. For what reason? Why am I trying to beat this arbitrary benchmark that has no reflection on my goals or what I am trying to achieve?
Ultimately, I was investing in assets that I believed would maximise my wealth, but when markets were toppy I often felt nervous enough to sell and take the cream off the top. Technically, I had made a profit – isn’t that what makes a ‘good’ investor?
Of course, I wasn’t considering the taxes, transaction costs or my long-term plan. I believed I needed to invest in a certain way to justify working in the job that I did. I would now classify myself as a passive investor. I’ve found investments that align to the goals that I am trying to achieve and I buy them at regular intervals. I am not out there always searching for new opportunities or undervalued assets. I’m measuring my success against the required rate of return I need to achieve my goal instead of an arbitrary benchmark.
Again, it’s not a foolproof plan. I spoke about how I recently deviated from my investment strategy. The market dipped in April and I found it difficult to not try and capitalise on lower prices (comparative to the very recent past). I am not a tactical allocator which means making adjustments based on opportunities instead of investment strategy. I have not found success with this in the past and it is not how I will achieve my financial goals. The best you can do as an investor is try your best to stick to it and minimise poor behaviour. We are going to make mistakes and all it takes to do better than most people is to limit those mistakes. The best behaviour that you can adopt is to let your investments supply the returns and not get in the way. To do this, find the right investment for you that you would be happy holding for the long-term. A comprehensive investment strategy will guide you and lower the chances that you will deviate from a written plan.
