Once you start learning about investing, it’s not too long before you run into the subject of fees associated with investing.
So. Many. Fees.
These fees tend to be small, whether in absolute number or in percentage. But as illustrated with compounding, don’t be fooled by small numbers, because these fees can add up in a hurry.
Let’s say you decide to invest by buying some individual stocks. Fees associated with individual stocks are relatively straightforward.
- Fees to keep your investments with the brokerage firm
- Fees associated with trading (buying/selling) stocks, although commission free trading exists as well
For those that want nothing to do with picking your own stocks (not recommended as a primary way to invest, unless you’re completely okay with potentially losing all of that money), mutual funds allow you to invest in a whole basket of investments within each fund. This is a great way to diversify your investments within the stock market versus stock picking.
However, mutual funds aren’t free. The SEC has this handout that breaks down some of the costs associated with mutual funds. There are two major categories: shareholder fees and annual fund operating expenses. I will highlight a few types of fees that you should know as an investor.
Sales Load: This is the commission that the brokers will take when they either buy (front-end) or sell (back-end) a fund. A no-load fund does not pay out any commission to a broker.
If you have a 5% front-end sales load and you have $1,000 that you would like to invest, then $50 would be taken off the top and go to the broker. The remaining $950 would get invested. This may not seem so bad, but remember the effects of compounding over time.
This also signifies that you’re probably getting your investments managed for you by someone else. That broker is directly profiting from you buying that fund, introducing some conflict of interest. Having someone manage your investments carries its own separate fees, which I will discuss later.
ANNUAL FUND OPERATING EXPENSES
The management fee is paid out to the fund’s advisors, or management team. Remember the portfolio manager with his/her own team working behind the scenes to maintain this fund? News alert: they don’t work for free.
1. Expense Ratio: This is the number that many people use to quickly assess whether a fund is expensive or not. This fee covers the operating costs of a mutual fund. These can also be expressed as basis points. For example, a fund with an expense ratio of 0.05 can be expressed as 5 basis points. An expense ratio of 1.05 is the same thing as 105 basis points.
The ER can vary widely depending on the type of mutual fund. Fidelity recently came out with a zero expense ratio index fund, which made some waves when the news came out.
Passive index funds, in general, tend to have the lowest fees. For example, the popular Vanguard Total Stock Market (VTSAX) index fund has an expense ratio of 0.04%. An example of an actively managed fund is something like the Vanguard Emerging Markets Select Stock Fund (VMMSX), which has an expense ratio of 0.92%.
You know that saying “you get what you pay for”? Well, this does NOT apply to actively managed funds. Just because it has a high ER does not correlate with how well it is being managed or how well it will perform in the future. It just means that it’s a more expensive fund to manage.
2. 12b-1 fees: These are fees typically associated with marketing, and many times, they will be included in the overall expense ratio.
AND DON’T OVERLOOK THIS EXPENSE
And I haven’t even gotten to another major expense related to mutual funds. These are the expenses you incur when you hire someone to manage your investments for you, such as your financial advisor or a roboadvisor.
Financial advisors get paid many different ways- I go into some of this with this post. One of the most common methods is through an assets under management (AUM) model. If they are managing $100,000 of your assets for you, and they’re charging a 1% AUM fee, then you are paying them $1,000 annually to manage your assets for you. That’s $1,000 that will not get invested and compounded in your favor, year after year.
As mentioned above, if your advisor is selling you loaded mutual funds or insurance products, then they will receive a commission. There are also advisors that charge a fixed, flat fee that can range from an hourly rate to an annual fee.
HOW FEES EAT AWAY AT YOUR RETURNS
Imagine that you have $10,000. You considered putting this in a savings account, but you want to grow this money, so you decide to invest it. Let’s assume that you’re getting an 8% return every year, and you’re contributing an extra $1,000 annually.
In a perfect world where there are no fees, 20 years later, you will have $96,032.
Enter fees, whether in the form of actively managed funds, broker fees, and/or financial advisor fees. They are effectively lowering your returns, so even if you get the same 8%, your net returns will be lower because of the fees.
20 years later, net 7% returns: $82,562
20 years later, net 6% returns: $71,064
2% doesn’t seem like a lot, but as you can see in this example, lowering your returns by 2% cost $24,968. Or in other words, you lost 26% of the value of your portfolio because of fees, despite the fact that the overall gross return was the same at 8%.
The Physician on Fire did a great post about fees, illustrating that you can actually lose millions due to fees. Go ahead and check it out.
ARE THESE FEES EVER WORTH IT?
There are plenty of online brokerages that do not have associated sales loads with their popular mutual funds. Low cost index funds are the way to go if your investment strategy is to simply track the market rather than trying to beat it.
When you have actively managed funds in your portfolio, remember that you are paying active managers to beat the market for you. If they cannot beat the market by the margin that you are paying them, then you did not get your money’s worth with the higher expense ratio.
If you’re using a financial advisor, then you need to be aware of all of the fees associated with using their services. Unfortunately, many people have no idea how they’re paying their financial advisors because they never bothered to ask. It’s one of those fields where the exchange of money for services rendered isn’t as straightforward as it is for pretty much any other service field. Many times, the money being paid is coming directly out of your investments, not out of your wallet. You may not feel like you’re paying anything, but your investments are certainly feeling it.
Of course, one shouldn’t be hiring a financial advisor for the sole purpose of increasing your investment returns. I would actually be wary of an advisor that claims that they can do this for you. A good advisor should be providing comprehensive financial advice in order to match your personal financial goals. They should help you build a portfolio that is realistic, not one that is showing you outsized future gains and pretending that those types of returns are guaranteed.
The value of an advisor is almost impossible to quantify, since you can only guess what sort of financial decisions you would have made without the advisor. But if you’re the type of person that needs the one-on-one help of a good advisor, then by all means, hire one. You just have to make sure you’re getting value out of that relationship. Otherwise, become a DIY investor or find someone that can give you a better value.
So fees matter, as much as a percentage here or there doesn’t seem like it. Your homework? Go ahead and take a look at your investment accounts and find the most recent statements. Hone in on the “fees and expense ratios” section of your statement if you have mutual funds. Then factor in the brokerage firm fees, as well as any financial advisor fees that may be associated with these investments. Now ask yourself if those fees make sense to you based on the types of returns that you’ve been getting and the quality of financial advice that you’re receiving. Use this link (different stock market indices) and this link (specifically looking at VTSAX) to see a recent history of annual stock market returns.
If you go through this exercise and realize that you’ve been paying way too much in fees, then you’re not alone. Like I said, there are plenty of investors who have outsourced their investing, and they have no idea how much they’re actually paying for their investments or for financial advice. Why not start educating yourself on the basics of investing and find your investing style? In this case, not only does knowledge mean more power, but it will mean more dollars that you get to keep in your pocket.