Google+

BBC Capital

Riskology

The myth of "getting what you pay for"

About the author

Ari has written about financial products and investing for The Wall Street Journal, Forbes, and Pensions & Investments. Find him on Twitter.  

(Harley Schwadron)

(Harley Schwadron)

“It’s expensive, so it must be worth it.”

“You get what you pay for.”

We use these phrases to justify paying high prices for everything from coffee to cars, and even moreso when it comes to financial assets.

High price must mean high value, right? Not exactly.

When you are investing, you want to keep as much of your investment as possible, so the more you pay in fees, the less you keep.

Nonetheless, an aura has developed around some of the highest-cost investments — hedge funds — while some of the lowest-cost options — index funds — hardly make the headlines.  

Index funds, particularly the exchange-traded variety known as ETFs, are attractive since you often pay minimal management and brokerage fees.  In return you’re promised returns on pace with the market — less minor costs. In short, you’ll likely do as well as the headlines and spend very little.

The largest (and cheapest) ETFs track broad, global stock and bond market indexes, published by the likes of Standard & Poor’s Dow Jones Indices, MSCI and FTSE.  Their expense ratios—roughly how much you pay to invest— are quite low. One popular fund, the Vanguard Total Stock Market ETF, charges just 0.05% in fees and has a minimum investment of just one share.

How thin are those expenses? Over the past three years, according to research firm ETF.com, VTI had an annualised return of 13.96%, exactly the same as the index it tracks.

On the other end: pricey, high-barrier-to-entry hedge funds. These are the ultimate in pay-for-performance and opportunistic investing. Hedge funds entice investors with promises of returns that are either “uncorrelated” to the broader market of stocks and bonds or supercharged to outperform. Stocks are returning 8%? A hedge fund might conjecture it could bring its investors — often well-heeled types paying upwards of 2% in fees just to get in on the game — returns that could be double that.  Investors have bought in wholeheartedly, even though they often have to pay an additional price of 15% to 20% for performance over a benchmark on top of management fees. Hedge fund assets are nearing $3tn.

Like index funds and ETFs, hedge funds boast a wide-range of investing styles and geographies. They are, however, harder for everyday investors to access without ponying up a lot of money to invest.

Get what you pay for?

So, do you get what you pay for? Does the high price really get you more value?

Of course it depends, but research consistently shows that when buying hedge funds and other forms of “active” management, such as traditional mutual funds, investors aren’t always getting the performance they paid for.

According to Hedge Fund Research data, standard stock and bond indices over the past five years have been trouncing hedge funds of all walks. In 2013, for example, the Standard & Poor’s 500 Index total return, with dividends, was 32.4%. The HFRI Equity Hedge Index was less than half that, at 14.3%. (To be fair, in the pits of 2008, the S&P 500’s total return was -37% and the hedge fund average was -27%)

How did we get here?

But it’s not just hedge funds that are challenged by index funds and ETFs.

Equity indexes, consistently and across almost every asset class from large-cap stocks to real-estate funds, beat active stock picking funds over time. That’s according to yearly reports by Standard & Poor’s Dow Jones Indices for the US, Australia and Canada, which compare the returns of broad stock and bond-market benchmarks alongside actively-managed mutual funds designed to beat those benchmarks. US fund firm Vanguard recently published its own take on UK funds, with the same conclusion.

Yet these funds cost a pretty penny when compared to index funds and ETFs.

According to the US-based Investment Company Institute, a trade association for fund firms, the asset-weighted annual expense ratio of all actively-managed stock funds was 0.92% in 2012. For index funds, that’s 0.13%.

So, for every $100, you’re paying 80 cents  for the privilege of underperformance! That’s right, you’re paying more for funds that attempt to beat the cheapsters, but in reality, you’re getting less in return AND shelling out more!

Focus on cost

Despite the higher costs and lower performance, investors are pouring as much money into hedge funds as we are into ETFs. In the first three months of 2014, for example, equity hedge funds brought in $16.3bn globally, according to HFR, and equity ETFs collected $17bn, according to ETFGI. (Globally, ETF assets now top $2.4tn, and, according to Vanguard, now comprise more than half of index fund assets in the US.)

So why are some investors obsessed with, well, paying more and getting less?

First, hedge fund managers are canonised and elevated in popular culture over “boring” index fund managers. They own yachts, sports teams, engage in extreme sports. In contrast, the modern father of the index fund, John Bogle, appears more on lists of the 20th century’s great innovators than on “rich lists.” Index fund managers tend to be academically-inclined quants devoted to “optimisation” and “tracking difference.”

And then there’s the enticing pitch by active managers in general. “We’re targeting specific areas of the market, using “hedged” strategies that mitigate risk!” “We’re taking outsized bets that require greater resources and expenses to earn you bigger returns!”  (Of course, some are alleged to have done so improperly and the largest managers have profited handsomely for themselves.)  

But the truth is, it’s an investment strategy that says Cadillac but aside from the higher price tag, won’t necessarily get you any further any faster, and certainly not for less, than a Honda.

The sizzle, and promise, of high-cost investing shouldn’t sway you from the hearty steak that comes with a focus on low-cost. In this case, how much something costs — its price — has little to do with its value.

To comment on this story or anything else you have seen on BBC Capital, head over to our Facebook page or message us on Twitter.

Why are some investors obsessed with, well, paying more and getting less?

BBC © 2014 The BBC is not responsible for the content of external sites. Read more.

This page is best viewed in an up-to-date web browser with style sheets (CSS) enabled. While you will be able to view the content of this page in your current browser, you will not be able to get the full visual experience. Please consider upgrading your browser software or enabling style sheets (CSS) if you are able to do so.