Many of my prospective clients come into my office either not knowing how much they are paying in investment fees or mistakenly thinking that they are receiving their investment counsel for free. It is no wonder this occurs. Fees are often embedded in the form of loads (either front-end when the fund is purchased or on the back end when it is sold), commissions, and expense ratios. These hidden fees make it difficult to ascertain total investment costs for your portfolio.
Many financial statements appear to have no fees deducted, but just because you can’t see a fee, does not mean it is not present and having an effect on your portfolio.
So how do you determine the fees you are being charged?
How much do you pay for advice? – Fee only versus Fee Based Advisors
First, if you use an advisor, you will somehow be paying for this advice. There are many ways advisors receive compensation.
A fee “only” advisor charges a fee based on either a percentage of your total assets invested, a retainer, or per project fee based on an hourly rate. This is the easiest and most transparent way for the client to be charged. Furthermore, with retainers and hourly fees, large portfolios are not charged egregiously high rates just because they have higher account balances. Note that true fee-only planners are in the minority in the financial advisory world. Hourly, fee only advisors are even rarer.
The downside of this approach is that since the client has to write a check for the amount, behaviorally it is less palatable for him, even if the charges are far less. Ironically, this enhanced awareness of the fee, even if it is substantially lower, makes the client more resistant to paying via this method.
Fee “based” advisors are distinctly different from fee only advisors in that they can charge a certain percentage of assets AND may also receive commissions on the products or funds sold to the client. This could be the case if your advisor who charges you 1% annually on your investment portfolio also gets commissions from the funds or positions in your portfolio or from an insurance product or annuity he or she sells you.
The ABC’s of Investment Fees
Most investors that go to a solely commissioned based brokerage are not charged a fee as a percentage of their assets. So, on the surface, it may appear that the advice they receive is “free.” Instead, the broker will buy funds that have a built in commission. These funds are often denoted by a capital letter after the fund. An “A” fund has a front-end load. Typically 4-6% of the total amount handed over to the advisor will go straight to him or her as commission. These fees may decline at certain breakpoints, particularly if you stick within one fund family. “B” funds have back-end commissions that normally decline over time, so it is best to hold on to these until they have expired. C funds have level but relatively high annual expenses. Due to these loads or commissions, load funds tend to have higher expense ratios, as well as potentially 12b-1 fees.
What are expense ratios and 12b-1 fees?
An expense ratio is the most common fee an investor will encounter. It represents the annual operating costs of the fund. Every mutual fund or exchange traded fund has this ratio, and, of course, you would ideally like to see these as low as possible. For example, active funds may have expenses ratios well over 1%, whereas passive index funds may have expense ratios less than .20%.
The 12b-1 fee is also considered an operational expense and, as such, is included in a fund’s expense ratio. It ranges between 0.25-1%, but is more often closer to 0.25%. It is primarily used as an incentive for the broker or rep to sell the fund and is paid to that broker annually.
Note that although active funds purport to “beat the market,” over two-thirds of these funds fail to beat their benchmark in any one year. See this related article. As you can imagine, the more of these active funds you add to your portfolio, the chance of you beating the market (as represented by index funds) over many years substantially diminishes. Thus, the increased expenses many investors pay a fund manager to “market time” or pick “winning funds” are often a waste of money.
Let’s look at an example to bring it all together:
Say I invest $100,000 in a fund with front end loads of 4.75%. The fund also has an expense ratio of 1.13% inclusive of a 0.25% 12-b1 fee, which goes back to the broker. At the same time, I decide to invest in a no load passive indexed fund in the same investment category.
After 5 years, assuming that the annualized rate of return for the category index is 10%, the total costs and return of the portfolio would be as follows:
Even though the expenses for the higher cost fund were perhaps not as transparent, the ending value of the investment shows the dramatic difference. This is why many investors scratch their head and wonder why their portfolio seems to underperform the market.
The moral of the story is costs matter, especially over long periods of time. Over just five years, in this example, the low cost investment balance is over 10% higher.
Make sure you fully understand all of your investment costs and how you are being charged. If future investment returns are expected to be lower than what we have historically experienced, keeping costs low is even more imperative.
If you invest in low cost funds and use a low cost fee only advisor consider yourself well-armed to defend against lower returns in the future.