Fees may take away from returns
When it comes to fees, nobody is excited about paying ‘em. That’s why it’s important to understand all of the fees that are associated with your investment accounts and activities.
Although fees directly lower your total investment returns (every dollar paid in fees is a dollar less in your portfolio’s return), they may also provide additional benefits. Fees may reduce your returns because your investment performance is calculated by looking at the change in account value (positive or negative). The impact of fees are considered to calculate the “net of fees return,” which is typically how investments are measured.
Find a fee structure that fits your needs
While no investor should strive to pay higher fees, the goal also isn’t to simply pay zero fees. This is because you pay fees in order to receive products and services, such as mutual funds and financial advice. The goal should be to pay the right level of fees, and certainly not overpay, for the types of products and services that make sense for your financial goals and personal situation.
The different types of fees
Fees can be taken at different stages of the investment process and by multiple parties. As with any consumer product, learning how different types of fees are charged, and whether they match the quality of what you’re receiving, is the first step in making educated choices. Here are the main types you’ll encounter:
Advisory fees are charged by your financial advisor for the services they offer. They are usually expressed as a percentage of assets under management and charged on a quarterly basis on average account balances. The advantage of this fee structure is that it incentivizes your financial advisor to focus on investment performance, rather than selling you products and aligns their interests with yours. Other types of fee structures include flat fees for financial plans or retainer models where the client can select his/her level of service and pay a monthly fee.
Commissions are direct trading costs. Every time you buy or sell securities, your broker or custodian will charge a transaction cost, for example $10 per trade. Some platforms charge per share rather than per trade, which is more cost-effective if you’re trading in smaller amounts, but can become expensive quickly. There can also be differences in costs based on the type of security, such as stocks, bonds, or options. If you’re planning to make a large number of trades in your account, this is an important fee to be aware of.
Custodial fees include all of the fees associated with where you hold your accounts, usually a broker or custodian, and are similar to what you’d expect to pay at a bank. Annual account fees, transfer fees and trading platform fees are common at brokers. The total cost of custodial fees depends on the broker or custodian you use and the type of account you have.
Expense ratios are the management and operating costs for mutual funds and ETFs and are presented as an annual percentage of the total investment. If an expense ratio is 1.00% and you’ve invested $1,000, then your annual expense will be $10. Expense ratios are generally lower for ETFs and other passive funds where the portfolio manager is following an index strategy. With actively-managed funds, where the portfolio manager may be trying to outperform an index, the expense ratio is usually higher. Expense ratios are also higher for funds whose underlying securities have smaller markets for trading or that employ more sophisticated investing strategies. The amount of the expense ratio is generally deducted from the value of that investment.
Sales loads are commissions paid to financial intermediaries for the purchase of mutual funds. Unlike expense ratios, which are paid to the portfolio managers, a sales load is paid to the distributor of that mutual fund. Like expense ratios, sales loads are also expressed as a percentage of the amount purchased. Some funds may have no-loads, but the maximum that can be charged is 8.5%. There are two main types: front-end and back-end. The front-end load is charged at the initial purchase and reduces your initial investment amount. The back-end load is charged if the investment is liquidated before a specified period as described in the fund’s prospectus.
There’s one thing you can control
While you can’t control exactly how your investments perform, you can control the fees you incur in your investment process. Thus, the goal of most investors should be to build the best portfolio and seek the most appropriate advice at the best cost.