Many investors would agree that minimizing investment cost is one of the basic tenets of sound investing, and critical to achieving long-term investment success.
In an era of miniscule returns and paltry yields, it is undoubtedly in the best interest of the investors to try to minimize their investment costs. After all, every dollar paid in fees or trading commissions is a dollar less of potential return.
Further, contrary to the typical economic parallel between price and value, higher costs in investments often do not lead to higher returns. As a matter of fact, a study in 1996 conducted by M. Gruber and published in the Journal of Finance, found that funds with the worst after-expense performance actually had the highest average expense ratio! The study also found that the performance difference between the worst and best funds exceeded the fee differences.
In a separate study conducted in February 2012, the Financial Research Corporation evaluated the predictive value on future performance of ten different metrics, including past performance, Morningstar rating, alpha, and beta. The study concluded that “expense ratios” were the single most reliable predictor of future performance, with low-cost funds delivering above-average performance in all of the periods examined.
As you can see from a study, higher cost does not equal better performance.
So what are some of the fees an investor should be aware of? Here is a list of some of the most common fees you may see, whether you invest by yourself, or with the help of a professional advisor.
Account Maintenance Fees
The most common obvious are the annual brokerage account fees charged by your custodian to maintain your accounts. The fee typically range anywhere from $5 a year to tens of dollars. It is common, however, for brokerage firms to waive this fee if your account balance reaches a certain level.
For the do-it-yourselfers who like to trade stocks and mutual funds on-line, the trading commission can range from $0 to $9.99 depending on the type of trade (stocks vs. options), and any special requirements (market order vs. limit order).
Load / Sales Charges
If you work with a commission based financial advisor, and that advisor recommends a fund for you to invest, that fund will be in all probability a “load fund”, and the load, or sales charge, is paid to the advisor as payment for their expertise in helping you pick a good fund. The load can come in two forms, either “front-end”, or ‘back-end”. When you invest in a front-end load, which averages around 5%, you immediately lose a big chunk of your money. In other words, only 95% of your money is put to work. You would have to first make the 5% back before you will start seeing a return on your investments. If you happen to invest in a fund with a “back-end load, then you are typically required to hold the fund anywhere between 6 to 10 years before selling in order to avoid a big commission on the back end.
Even if you invest in funds that do not have a load or sales charge, you will still be charged an “expense ratio”, which represents the percentage of the fund’s asset that go purely toward the expense of running the fund. The expense ratio is an all inclusive percentage that covers the investment advisory fee, the administrative costs, 12b-1 distribution fees, and other operating expenses.
Some brokers, mostly seen at big wire houses, will charge one single fee and then invest your assets in a diversified portfolio of stocks and bonds. The brokerage commissions and advisory fees are wrapped in the overall fee. It may sound like a mutual fund, but it is not. The “wrap account” carries some significant baggage since it is difficult to ascertain the validity of past performance data. The choice of a manager is left to your stockbroker and, depending on the relationship between the adviser and the broker, may involve a potential conflict of interest. Most importantly, the costs involved in wrap accounts are very high. Maximum annual fees typically total 3% of assets, with reduced fees available to investors with assets of $1 million (2.5%) or $5 million (2%). Hidden execution costs may add another 0.5% or more to the fee. The payment of any sales charges would raise the cost more.
Advisory Fee is the fee that a Registered Investment Advisory firm charges for making investment decisions on behalf of a client. Unlike a “wrap fee”, the advisor typically would be making all the asset allocation and investment decisions, versus outsourcing to yet another third party. Asset management often opens up more potential investment vehicles to the client, and theoretically, asset managers have more knowledge and experience in making appropriate investment decisions than the client. Typically, the fee is a small percentage of the assets under management. Historically, professional asset management is often open only to institutional investors and high net-worth individuals. But many large brokerage firms have started offering advisory services to clients with as little as $25,000 to invest.
It is important to keep in mind that not all “fees” are bad. The fees charged by a competent investment advisor are no different than those charged by a good accountant or an attorney. You are simply paying for a service that you otherwise cannot perform, or perform as well on your own. However, like any good consumer, it is always a good idea to shop around and find an advisor that truly has your best interest at heart.