Understanding Investment Fees

in Investing-RSS, Personal Finance Essentials by

Fees and costs can have a significant impact on investment portfolios. Unfortunately, many people don’t know the full extent of what they are paying. Our dashboard can help you quantify direct fund fees, but there are often many hidden costs. You should have a firm grasp on both before making any investment decision.

Mutual Fund and ETF Costs

Mutual Funds and ETFs have four main sources of costs:

  • Expense Ratio: This is the direct fee charged for asset management, typically ranging from near 0.1% to 2.0% per year. For example, if a mutual fund has an expense ratio of 1.0%, the fund will deduct $10 each year for every $1000 you have invested. The average mutual fund has an expense ratio of 1.15%, according to Lipper. As a rule, passive funds which attempt to track an index have lower expense ratios, while active managers trying to beat a benchmark have higher expense ratios.
  • Load Fees: Some mutual funds deduct a percentage of assets upfront (front-end) or when the fund is sold (back-end). Load fees are essentially commissions paid to the broker who sold them. Many financial professionals consider load fees unfair to the client.
  • Trading Costs: These are hidden costs. When a portfolio manager trades inside a fund, the fund must pay commissions to the executing broker. Often more important is the “spread”. Each stock has a bid and an ask price. The spread between them is essentially lost when buying and selling. This can be significant, particularly for small cap stocks. Some studies have shown internal trading costs average over 1.0% per year in the average active mutual fund. Passive index funds tend to trade less and, therefore, have lower trading costs than actively managed funds.
  • Market Impact: Another hidden cost. When a large fund buys a stock, it often pushes the price higher. When it sells, it pushes the price lower. This detracts from performance and can be a significant drag in high turnover funds.

Many mutual funds have multiple share classes where the only difference is the fee. “A-Shares” typically have high front load fees and lower ongoing fees. “B-Shares” have back-end load fees which diminish to zero over time. During this window they often have higher ongoing fees than “A-Shares”. “C-Shares” have no load fee but higher ongoing fees in perpetuity.

We believe active mutual funds were a great innovation for their time but are no longer appropriate for investors with more than $100,000 in liquid assets. Most active mutual funds come with high costs, but fail to beat their benchmarks. In addition, they tend to be horribly tax inefficient. We believe using passive ETFs or a properly constructed portfolio of individual securities can be far superior.

Advisory Costs

If a professional is managing your portfolio, you likely pay a percentage of your assets as a management fee. These fees typically range from less than 1.0% to more than 2.0%. For many investors, these fees can be well worth paying, but the quality and level of service provided varies greatly. Some advisors will help you with asset allocation and financial planning topics while others simply pick stocks or funds. Paying 1.5% or more for advisory costs is generally considered excessive. Many advisors charge high fees and then buy active mutual funds which also charge high fees. This double layer can be very costly.

Some brokers charge an advisory fee and also earn commissions on product sales or trades. This is a dangerous situation because this person has a significant conflict of interest.
If possible, make sure to use a fee-only advisor, not a broker. If you are not paying an explicit fee, your advisor is almost certainly making money on the products you buy. Many mutual funds pay kick-backs to advisors for recommending them.

Broker-Dealer Registered Investment Advisor
*Recommended investments must be “suitable” *Fiduciary responsibility to focus on client’s interests
*Generally commission based *Fee based
*Prices must be “fair and reasonable” *Must take reasonable care to avoid misleading clients

Trade Commission Fees

In the old days, brokers were primarily compensated by trade commissions which could be very expensive for investors. The evolution of online trading has lowered trade costs, but they can still be significant in many cases. Discount brokers typically charge between $4 and $20 for a typical trade, while trades made through a traditional broker can be significantly more.

Today, most brokers make significantly more money from product kick-backs than actual trade commissions. Many mutual funds pay broker’s an up-front fee and/or an ongoing “trailer” for placing client assets in the funds.

Plan Administration

This relates to active retirement accounts such as a 401k, 403b, or 457. Plan administrators will often charge your account for items such as record keeping. These costs typically range from 0.0% to 1.0%. It is important to know what your company’s plan charges. Most participants are unaware.

Annuities and Insurance

Deferred annuities and Whole life insurance policies often pay huge commissions to sales representatives. This creates large conflicts of interest to push these products. It also results in very high fees being charged to buyers. It is critically important to understand the product and fee structure before buying a deferred annuity or whole life insurance policy.

Most variable deferred annuities have all-in costs of 2.5% to 4% per year. If you are paying over 3% for an annuity, there is very little chance it will turn out to be a wise purchase.

Please contact us if you would like an opinion on an insurance product you own or are considering. We have seen too many people deeply regret purchasing these products.

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.

3 comments

  1. Dale Fisher

    My financial adviser is a Edward Jones broker. I feel there purchase & selling fees are quite a lot. He says it’s around 6%. Do you feel this a reasonable fee?

    Reply
    • Anonymous

      you are kidding, right?

      Reply
  2. vanbogart

    Your thoughts on the new state run mandated California retirement saving law (AB1234)?

    Reply

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.