When it comes to managing their investments, many people are simply unaware of what they're paying. We are often tempted to turn a blind eye to fees, especially when feeling uncertain about how things work or even the questions we should be asking. Thus, in this article, I'd like to explain some of the commonly overlooked fees that are involved in investing. Whether you're happy to pay for the services of a trusted advisor or unhappy with your situation, you should certainly know about how fees work and what they are. As I always say, knowledge is power!
Account Fees
The most straightforward fee you may encounter is the annual asset management fee. This is a fee charged directly out of the account and is often expressed as a fixed percentage of assets under management; for example, your advisor might charge 2 percent per year. Depending upon the arrangement, it is most likely to be charged quarterly in advance. However, the annual management fee is not a given: Some advisors charge all clients a flat annual fee; alternatively, some work only on a commission basis, in which a dollar amount is charged per transaction. Some advisors will set up two separate accounts, one being a fee-based account and the other as a commission-based account.
For example, if you want an actively managed, diversified portfolio, you may find that most advisors will quote a flat fee. This is because these accounts require consistent re-examination, careful trading, rebalancing, tax harvesting, etc. On the other hand, if you find there have been absolutely no changes to your fee-based account in the last two or three years, you should probably not be paying an annual asset management fee.
Mutual Fund Fees
If your account is invested in mutual funds, you may also be subject to two additional fees. The mutual fund's annual expense ratio is the most commonly known, and it covers the mutual fund's fixed and ongoing expenses, such as portfolio manager salaries, customer service reps, and the printing costs of prospectuses and marketing materials.
While it might sound mundane, you should always be aware of your mutual fund expense ratios because they can vary widely and because these fees are not listed on your account statement or trade confirmations. An easy way to learn about expense ratios is to visit Morningstar.com, where you can type any fund's name or symbol into the search box and find basic information, performance numbers and a fee report. It's a great, easy-to-use tool that will really help you learn about your investments!
Once you know a given fund's expense ratio, you need to take into account several variables before determining whether it's reasonable. Actively managed mutual funds typically carry higher fees than index funds, and, generally speaking, international or emerging market funds are more expensive than your average S&P 500 fund. A knowledgeable advisor can help you balance fees by constructing a portfolio that meets your investment objectives while keeping fees at reasonable levels. It may sound daunting, but don't be reluctant to ask about this! Overloaded fees can eat away at your portfolio's value over the long run, so it's important that you understand your advisor's reasoning for building your portfolio in a particular way and feel comfortable with your account fees.
Most people think that the expense ratio is the whole story when it comes to mutual funds. However, mutual funds also charge fees for brokerage commissions and trading expenses incurred. Of course, a mutual fund's trading fee structure is likely far lower than anything an individual could command, but more trading still equals more fees. In order to find out about these ongoing variable expenses, you can't rely on the expense ratio. You have to look at the fund's annual Statement of Additional Information (SAI). This information is not required to be mailed to you like the fund's prospectus and can be difficult to quantify, even when using information available online.
While it can be difficult to locate and most people don't know about it, I believe it's important that you're aware that this information does exist and that it is something you can find.
As you can see, the possible fees can add up quickly. For example, suppose you have a basket of mutual funds and are paying a 2 percent asset management fee, an average of 1 percent in expense ratios, and trading fees (as noted in the SAI) of roughly 1 percent. In this case, your break-even requirements in terms of performance are suddenly a lot higher than you may have anticipated (please note that these numbers are fictitious). There is nothing wrong with paying fees, but you need to know what you're getting in return.
Now, whether a given fund's overall fees are reasonable is a question that is best resolved through a discussion with your advisor, but you should not be afraid to ask about total costs.
Getting What You Pay For
I can't stress enough the importance of understanding the asset management fee, expense ratio, and additional expenses from the SAI. I often see potential clients who rolled over their 401(k) into an IRA and who pay an annual asset management fee to their advisor... but haven't seen a change in their portfolio in two or even three years. Other new clients have money in an old 401(k) and are constrained by limited investment options and unsure of their real fees, which are typically much higher than you might think due to administration costs. These stories are repeated all too often, and with a little bit of diligence you can avoid such traps and get your assets into an investment program more suitable for your needs.
Now, you may think that as long as returns are meeting your expectations that total costs don't really matter. I wish it was that easy, but unfortunately, relying on high returns is not enough. Most importantly, you need to consider how much risk you're taking on and whether the asset management fee and portfolio strategy make sense. If you're paying for active management, you should be getting it, and any portfolio should be grounded in an understandable investment philosophy. Finally, remember that you pay fees both in good markets and in bad, so trying to establish some downside protection and risk management strategies are important issues relevant to both performance and cost.
Reducing Fees
When it comes to fees, we all know that we need to pay for advice and asset management, but we're sometimes afraid to ask about costs. A good advisor will always talk to you about his or her management fees and mutual fund expense ratios and won't be afraid to investigate lower-cost alternatives. Indeed, there are many ways to build cost efficient portfolios; for example, instead of building a diversified portfolio consisting only of mutual funds, you might add a mix of mutual funds, Exchange Traded Funds (ETFs), and individual stocks.
ETFs track specific sectors of the market just like index funds, but trade just like stocks. This means that an ETF's price varies throughout the day and you can buy a single share, sell short, or even purchase on margin (though for the vast majority of investors, I believe the latter two activities rarely, if ever, make sense). ETFs have lower fees than most mutual funds, and their flexibility can make them an attractive part of your portfolio.
Individual stocks can also be an option. While you still have to pay the associated transaction costs, stocks don't carry any annual fees. Of course, whether individual stocks make sense for you is dependent on a lot of factors, including your risk tolerance. While a single stock could return a huge percentage gain (or loss) in one year, you take on a lot of extra risk by buying it. Make sure you understand the risks and benefits of adding stocks before you consider them.
Finally, depending upon the situation, I generally advise clients to implement downside protection and risk management strategies, as these can help alleviate the pain of bad markets and provide cushioning against additional costs. Take a look at my articles Institutional Investing for the Individual Investor and Managing Your Downside Risk is a Must for more information.
Making Your Portfolio Work for You
In the end, of course, proper asset management comes down to the big picture. It's about building the portfolio that is right for you, which should take into account not just cost, but the risk you're willing to take on, whether you're seeking active or passive management, and whether there are other services that you receive in exchange for the fees you pay.
It's critical that you understand and are comfortable with your management plan, and the best way to ensure that is through education. With this primer on fees and fee structures, you have taken the first step in understanding some of the important details about the management of your accounts, which gives you the power to steer your portfolio management in the direction that is right for you.
Written by Bradford Pine with Anna B. Wroblewska. Learn more about the Bradford Pine Wealth Group here.
