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“Do more of what works and less of what doesn’t.” -Steve Clark
“Don’t focus on making money, focus on protecting what you have.” -Paul Tudor Jones
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A question asked often over the years is: “Do investment costs make that big a difference?”
Or, more simply stated: “Do costs matter?”
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Any veteran of investing knows that there is no free lunch. Investing involves costs! Anyone new to investing, an investing “Newbie”, may be unaware of the scope and extent of investment costs.
This blog will speak about investment fees and how to minimize them.
The first two commandments for investors should be: don’t be ignorant and don’t be naive.
I’ve stated before that knowledge is power. The more knowledgeable and less ignorant a person is about investment fees, the more capable they are of minimizing costs. Don’t be naïve and think that a broker or financial advisor is acting in your best interest. Even if they are fiduciary advisors, there is always tension between the interests of the advisor and client. Advisors must maximize income for themselves or their firms and may do so at the client’s expense. Fiduciary advisors don’t have to act as fiduciaries in every transaction. For additional insight please see THE QUEST FOR THE RIGHT ADVISOR: EFFECTIVE STRATEGIES AMIDST MULTIPLE DESIGNATIONS #1 and THE QUEST FOR THE RIGHT ADVISOR: EFFECTIVE STRATEGIES AMIDST MULTIPLE DESIGNATIONS #2.
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Investment Costs
Investment costs affect the long-term performance and terminal value of investment accounts.
Below, I have listed some tangible and intangible costs associated with investing:
Trading fees– When I began trading individual stocks, these trades involved a 3% commission for buying or selling stocks. Over time, these commission rates have declined and appear as a flat fee per stock or ETF transaction. Brokerages that now offer commission-free trading include Fidelity, Charles Schwab, E*TRADE, interactive Brokers, and Robinhood. When applicable, commission fees range between three and seven dollars depending on the broker, and high-volume traders may pay even less.
Management fees- Internal– Internal fees are bundled into what I have termed “Internal Management Fees.”
*expense ratios– expense ratios are associated with mutual funds. Expense ratios represent the cost to manage the fund and are a percentage of the total investment (a 0.10% annual expense ratio will cost $1 per year for every $1000 invested.)
*12b-1 fees– these fees are annual marketing and distribution fees. They do not apply to all funds. 12b-1 fees are included in the expense ratio and represent money paid to brokers to market mutual funds.
*annual fees– some funds charge annual fees (Usually under $100 for Accounts with lower balance amounts) and these fees represent costs associated with IRS reporting regulations.
*custodial fees– custodial fees are part of a mutual fund’s annual expense ratio. In many cases, management and administrative costs are a part of custodial fees.
*loads and commissions– loads are fees charged when buying (front-end load) or selling (back-end load) mutual fund shares. A commission is a fee paid to a broker for brokerage service.
*purchase or redemption fees (also termed transaction fees)– are fees charged by brokerages. In some cases, they may also be termed loads (see above.)
Management fees- External
I have loosely termed these fees as external management fees. These are additional fees not included in expense ratios and internal management fees by mutual fund companies.
*AUM models– advisors may charge annual fees based on AUM (assets under management.) These fees are deducted from accounts periodically, ranging from quarterly to annually. Fees range from 30 basis points to 250 basis points (0.30% to 2.5%.) Some advisors may also charge commissions on products sold.
*Fee-only advisors– most fee-only advisors charge a percentage of assets under management, or some type of flat fee (hourly fees or retainers.) Many fee-only advisors also charge a commission from the sale of certain specific investments.
*flat fee models– usually provide one time or more limited types of service. In many cases, a flat fee advisor will charge a fee of several thousand dollars to formulate a comprehensive retirement plan. Some flat fee planners charge a smaller annual fee to review and update clients’ retirement plans. Flat Fee advisors do not manage investments, charge AUM fees, or charge commissions.
Opportunity Cost– The most severe hidden cost is the lost opportunity cost of dollars paid for investment costs. For more information on this topic please see FUTURES IN FOCUS: OPPORTUNITY COST AND TIME VALUE IN RETIREMENT PLANNING. Dollars paid in management fees, custodial fees, and expense ratios are unavailable for growth and compounding. For example: if an investor pays $1000 each year in investment costs and that thousand dollars was invested instead at 8% return per annum, the same $1000 annual expense would be worth over $122K ( the opportunity cost of a $1000 annual expense would cost the investor over $122,000 in lost earnings over 30 years.)
This example by Nerdwallet illustrates the same concept in a different manner:
Even small brokerage fees add up over time; a few investment fees together can significantly reduce your portfolio’s return. If your portfolio was up 6% for the year but you paid 1.5% in fees and expenses, your return is actually only 4.5%. Over time, that difference really adds up.
Take this example, in which an investor puts $500 a month into a brokerage account each year for 30 years, depositing a total of $180,000 over that time and earning an average annual 7% return.
The last column in the chart shows how much would be lost to fees over the course of 30 years. An investor who paid 2% in fees each year would give up more than $178,000 over 30 years, almost as much money as the $180,000 deposited in the account during that time.
When seen in this light, it becomes much easier to understand that investment costs and the percentage of these costs certainly matter!
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Reducing Investment Costs
- Don’t be ignorant– educate yourself and ask questions (call customer service of the brokerage firm or mutual fund company.)
- Don’t be naïve– understand that there are costs involved in investing. Also, understand that advisers, even fiduciary advisers, generate fees and make a living. Their needs sometimes conflict with the needs of their clients.
- Brokerage fees are not tax deductible.
- Explore the website– brokerage companies and mutual funds legally must disclose fees to investors. Brokerage companies must provide a Form CRS that summarizes the main fees for each new account holder. There are also usually links to a more comprehensive fee schedule. Mutual fund companies must include a standardized fee table in their prospectus. Advisory firms must disclose all fees and advisory services in Form ADV Part 1A.
- Fees may appear deceptively low, but the aggregate combination of different fees may raise the cost appreciably.
- Buy and hold– one of the simplest strategies to reduce brokerage fees is to buy stocks or mutual funds and hold them for long periods. Unscrupulous advisors frequently buy and sell stocks in a process known as “churning” to maximize commissions on the sales of stocks. Less portfolio turnover (buying and selling) means fewer transaction fees.
- Tax implications– one of the least understood and most often ignored parts of investing. According to Investopedia: Many investors are unaware that realized losses on investments—that is, money lost after selling a stock for less than it cost, can be used to offset taxable gains. This is called tax-loss harvesting. Ordinarily, an investor will pay either a long-term capital gains tax (securities held over one year) or short-term capital gains tax (securities held for less than one year). If it’s a long-term capital gain the investor will pay either 0%, 15%, or 20% depending on their income level and their filing status (single, married filing jointly, married filing separately). Short-term capital gains are taxed as ordinary income. These rates range from 10% to 37% again, depending on your income level and filing status. Investors might be surprised to see how much they hold on to with a tax-deferred, or tax-exempt account. Tax-deferred accounts, which safeguard investments from taxes as long as the assets remain untouched, include 401(k)s and traditional IRAs. These account options are great ways to save big on burdensome taxes. However, there’s a catch. As mentioned earlier, you’ll lose the tax advantage (and get hit with penalty costs) if you withdraw money early; before the age of 59½. Younger investors should consider ROTH IRA accounts. Provided you have owned the Roth for five years, both earnings and withdrawals made after 59½ are tax-free. These are great ways to save over the long term if you know you won’t need to touch the money.
- Use no-fee brokers– most online brokers no longer charge fees to buy and sell stocks.
- Low cost Index Funds– most passive index funds charge very minimal fees.
- No Load Index Funds– although some funds, specifically actively managed funds, charge loads. The majority of mutual funds (especially passive index funds) charge no load to buy or sell shares.
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Final Thoughts
Always understand that no one will be more concerned about your financial welfare than you will be concerned. It’s each individual’s responsibility to monitor investments, especially investments managed by someone else.
Most advisors are honest and hard-working people. But, even honest advisors must make a living, and that creates a tension between the interest of the advisor and the best interest of the client.
There are always costs associated with investments and asset management. Each investor must be aware of and manage those costs to the best of their ability.
Knowledge is power, and the more you know, and understand about costs, fees, and tax management of your investments the better off you’ll be!
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