Minimizing Investment Costs
Do you really know how much you paid last year in investment fees? We all know it’s not free, even if you manage your own accounts.
The topic of investment costs is one that comes up in my office frequently. Calculating investment fees properly is critical to evaluating any investment management approach. Investment costs directly impact the success of your investment strategy.
When prospective clients bring in statements of their existing accounts, many are surprised to learn that they are paying much more than the annual account fees shown on their statements. I often ask how much they pay in advisory and investment costs on an annual basis. Very few are able to provide even a ballpark answer to the question.
WHY DO I NEED TO KNOW HOW MY ADVISOR IS PAID?
Unfortunately – and to the detriment of many investors – the financial industry has created confusion regarding fees and compensation for advisors and companies who provide investment and financial planning advice. Pressure is building to replace the “Suitability Standard” with a more stringent “Fiduciary Standard.”
- “Suitability Standard” is a requirement to have reasonable basis to believe that an investment strategy is suitable for the customer based on several criteria.
- “Fiduciary Standard” is a requirement to act with undivided loyalty to the client, including disclosure of how the financial advisor is to be compensated and any corresponding conflicts of interest.
This move has been fought constantly by the brokerage industry (which includes bank-owned brokerages) from the moment of introduction. Why is this? By allowing consumers to correctly and clearly gauge their costs, they would be able to “shop” the financial industry and such businesses would have to lower their rates to make themselves competitive. A fiduciary standard would threaten their business model and cost them too much money.
Clients have a right to examine the fees they pay. If you are a do-it-yourself investor, you want to reap the rewards of your efforts without unnecessary investment costs. If you do work with an advisor, you should understand your fees in order to make an appropriate cost vs. benefit decision. There’s an orderly way to calculate your investment costs and I’ll walk you through it. So, take out your paper, sharpen your pencil, and let’s get to work.
BREAKING DOWN INVESTMENT & ADVISORY COSTS
In general, there are six types of investment costs: advisory fees, commissions, loads, internal investment expenses, fund transaction costs, and annual account fees. You will pay some of these costs whether you have an advisor helping you or not.
AM I PAYING TOO MUCH IN ADVISORY FEES
Advisory fees are commonly calculated as a percentage of your account value and are paid to a fee-only advisor or to a fee-based advisor. There is a significant distinction between a fee-only advisor and a fee-based advisor.
- A fee-only advisor does not accept commissions for investment work. Fee-only advisors charge only a fee (hourly or annual) and do not earn commissions.
- A fee-based advisor is able to accept either a fee or a commission. Fee-based advisors are almost always brokers representing one broker-dealer/custodian (aka brokerage) who hold multiple brokerage and/or insurance licenses.
Advisory fees vary and can range from 0.25% up to 2.50% of your account value. Hourly fees generally range from $150 to $300 per hour.
HOW MUCH IS A REASONABLE COMMISSION
Commissions are transaction costs you pay to your broker to buy or sell a security (stock, bond, index fund, etc.) in your account. Discount brokerages (Charles Schwab, TD Ameritrade, Vanguard, etc.) provide lower commission rates for their clients than full-service brokers who are being paid for their advice and service. Commissions vary depending upon the security being purchased and the amount of shares bought or sold and can range from a flat $9 per transaction at discount brokerages to several thousand dollars per transaction at full-service brokerages.
SHOULD I PAY COMMISSIONS PAID ON MUTUAL FUND PURCHASE/SALES
Loads are commissions paid to your broker for the purchase or sale of mutual funds. Loads are sometimes referred to as alphabet soup because they have a letter (A, B, C, I, N, etc.) after the name of the mutual fund. Each letter provides a clue as to how your broker is paid the commission. A-shares are referred to as front-end loads and your broker is paid a percentage of the investment as a commission when the fund is purchased. The percentage varies depending on the amount invested but can range from 0% on amounts over a million dollars to 5.75% on smaller amounts. B-shares are referred to as back-end loads and are paid if you sell a mutual fund before a period of time elapses. B-share loads can range from 0% to 5%. C-shares are commonly called level load funds and do not impose a front or back end charge. However, they usually impose a 1% deferred sales charge if the fund is sold within one year.
WHAT ARE INTERNAL INVESTMENT EXPENSES
Internal investment expenses are detailed as annual operating expenses within a fund’s prospectus. Internal fees are found in investments such as mutual funds, index funds, closed end funds, etc. Individual stocks or bonds do not have internal fees. These fees are withdrawn as a percentage from each fund, which ultimately reduces shareholder return. They can range from 0.05% on the amount invested for an index fund to well over 2% for specific mutual funds. Some funds charge internal “12b-1 fees” (sales, distribution, and service charges paid to the distributing brokerage). These can often range from 0.25% to 1.00% per year and are embedded within the total annual operating expenses. Not all funds charge 12b-1 fees.
FUND TRANSACTION COSTS: ARE YOU AWARE OF “TURNOVER”?
All packaged investment products (mutual funds, ETFs, etc.) pay transaction costs (or trading costs) whenever they buy and sell their underlying holdings. If a fund manager trades frequently, the fund’s trading costs will be higher. This repeated trading is called turnover and is expressed as a percentage of the average value of the portfolio. A 50% turnover rate implies that the fund buys and sells over half of its portfolio in a given year. Higher turnover equals higher fund transaction costs. These costs are in addition to the internal investment expenses described above.
ANNUAL ACCOUNT FEES: NOT AS STRAIGHT FORWARD AS THEY SEEM
Finally, many brokerages will charge an annual account fee to open and maintain an account for you. This can get complicated because there are often waivers if you meet certain criteria (asset amounts, revenue generated by your accounts, etc.). Annual account fees often range from $0 for discount brokers to $75 and higher per account for full service brokers.
One size does not fit all and we’re all unique in our investment circumstances. My advice to you is, do the work, pay attention, and understand your costs no matter how much you have invested. If you work with an advisor or broker, ask them to break down the fees using this format. A reasonable, all-encompassing rate when working with an advisor is 1.5% per year or less. If you manage your own portfolio, there may be fewer moving parts to calculate but there are still costs involved. Doing it yourself, you should be able to keep your fees below 0.5% per year.
The costs can be amplified if you have a large nest egg and are unaware of your full investment expenses. Be a good shopper of investment products and advice, as financial services can be a confusing industry for many consumers.
We are available to assist you with questions or concerns regarding your own personal investments.
Kevin Byrne, CFP®, MS is the owner of Byrne & Company Wealth Management, LLC (BCWM) and is a Registered Investment Advisor in Washington State. BCWM is a Fee-Only financial advisor and a member of NAPFA. www.byrneandcowealth.com.