A Dave Ramsey (Ramsey Solutions) article on investment fees opens with this:
Just like airline fees, investment fees are also a fact of life. The difference is, investment fees aren't always as clear as an extra baggage fee. Many folks we talk to are confused or blindsided by them. And sometimes, that confusion keeps people from making good choices about what to invest in. Let's clear the confusion so you can invest with more confidence.
The article describes the different types of fees, and in some cases, a justification for them (such as the up-front fees, called "loads," associated with investing in certain types of mutual funds—with all due respect to Mr. Ramsey, I'm not a fan of them, by the way).
I agree that investment fees are a fact of life; it costs money to invest. Regardless of whether you invest in a mutual fund or exchange-traded fund (ETF), or if it's actively or passively managed, there will almost certainly be a fee (although a few zero-fee funds have recently come on the scene).
I need to say up front that I'm not opposed to paying advisory fees or investment fund fees in principle. I own mostly passively but some actively-manged funds, and I'm comfortable with the fees I pay for the value I receive. We all deserve to be paid for our work (1 Tim. 5:18), and that includes financial advisors, investment fund managers, and fund custodial firms.
Most are conscientious, hardworking, and capable fund managers and advisors who are not out to rip you off. Just the same, there are bad apples out there and badly managed funds, so you need to know what fees you are paying and how much.
As an investor, if you're not happy with the product or service you receive in return for the fees you're charged, you can always go elsewhere, though switching isn't easy. Those investing in employer-sponsored 401(k)-type plans with limited investment choices will have fewer options.
You may think they don't matter too much one way or the other. So, in this article, I'll discuss the ones you're most likely to incur and whether specific fees (especially those paid to financial advisors) matter that much or not.
Fees you see and those you don't
Some expenses and fees are obvious and explicitly stated in prospectuses and advisor agreements; others are not. Or, if they are, they're confusing (or, perhaps more accurately, consumers are confused by them).
For example, a recent study by State Street Global Advisors found that almost half (47%) of investors surveyed think the management fees for mutual funds and ETFs are part of the advisory fee they pay their advisor or investing platform. (They are not.)
Another challenge in understanding the fees involved with investing is that there are quite a few that you may pay depending on what you invest in and how you do it. Some are a given but can be minimized. Others are more discretionary based on the choices you make.
Fund mangement fees
I already mentioned that almost all mutual funds and ETFs charge a fee to cover ongoing fund management and operating expenses. They are usually expressed as an expense ratio as single-digit or decimal percentages (1.0%, 0.50%, etc.) and even basis points (one-hundredth of one percent). They typically range between 0.05% (which is 5 basis points) and 1.5%.
A fund that has a one percent (1%) expense ratio will "cost you" 1% of whatever you have invested in that fund. But that can be misleading, so it's important to know how these fees are paid.
You won't see a transaction line item on your brokerage statement labeled "XYZ mutual fund fee." Instead, they are deducted by the fund managers from the fund's earnings. So, if a fund earns 6% with a 1% expense ratio, it will report a total return of 5%.
Most people, understandably, focus on the 5% return, not the 1% fee. And you won't notice that the fund managers are taking a fee of 1% unless you look closely (they are required to report it). And if you're happy with a 5% return in exchange for a 1% fee, you're good to go (more on that in a little bit).
The good news is that fund fees have been declining in recent years. Both mutual fund and ETF fees have been going down, and, as said, a few funds (ETFs) out there charge zero in fees.
Trading transaction fees
These are the costs to buy and sell stocks, bonds, mutual funds, and ETFs. Many mutual fund companies and online brokerages now offer $0 trades, so these costs are easy to avoid. Others, especially traditional bank brokerage operations, are still charging for transactions.
I have an IRA at Fidelity, and I can buy and sell mutual funds and ETFs without a transaction charge. However, if I were to move my account to a "full-service" brokerage and hire an advisor to manage it, I could be charged a $19.95 transaction charge whenever my advisor (broker) makes a trade on my behalf if the fund that's not on their fee-free list. I may also be charged fund sales commissions and other fees.
Advisor fees for services
There are basically two ways investment advisors are paid: 1) by a percentage of assets under management (AUM), or 2) by a fixed or hourly fee. Most charge a percentage of AUM, and the industry norm is around 1%.
That said, somewhat counter-intuitively, most have a sliding scale such that those with lower balances pay a higher percentage of AUM than those with larger balances. For example, someone with a $500K balance may pay 1.25%, whereas someone with a $1.5Mil. balance may be charged .75%.
As with fund fees, these costs have been going down as well. Some "big boys," such as Vanguard, now offer basic advisory services for just 30 basis points (0.30%). Both Fidelity and Schwab are in the 1.0% range. Robo-advisors (computers, not people) like Betterment and Wealthfront charge even less—in the 15 to 25 basis points range.
Unlike fund fees that reduce a fund's total return, these fees come "off the top"—you'll see them (or you should) as a debit transaction in your monthly, quarterly, or annual brokerage account statement.
Some advisory firms that charge you an advisory fee may also direct you toward their own managed funds that also carry a fee, the equivalent of "double dipping." (They make more money that way.) If your advisory fee is .85%, and you pay an average of 0.5% in fund fees, your total fee expense will be 1.35%.
I want to pause here and say that there isn't anything inherently evil or wrong with this kind of arrangement. But if you have questions, don't be shy about asking your advisor whether there are lower-cost options. If they can explain why their fees and recommended funds are better, and you're satisfied with their explanation, then fine. If not, seek out better alternatives (including a different advisor if you need to).
In place of a percentage of AUM-based fees, many advisors have turned to hourly or fixed fees for their services. This is a positive development as this approach favors the client as the total cost is likely to be much less than the AUM approach, especially over long periods. You might be charged an initial fee to set up your portfolio and then a smaller one to revisit if once every year or two after that.
Front-end (load) fees
Some mutual funds (not ETFs) charge front-end fees called "load" fees. These are paid up-front when you invest in a fund that has this fee. (There are sometimes back-end load fees when you sell, especially if you don't hold the fund long enough.)
Front-end fees are typically large (in the 5 to 6 percent range). This is why I think most people should stay away from such funds—your investment has "lost" 5.75% before you even get started. And not only do you lose that amount upfront, but you also forfeit the compound growth you would have received over time. (More on that in the next section.)
Some claim that the quality (performance) of a particular fund justifies the large up-front charge. That seems to me to be a difficult case to make, but you could take that into consideration.
Fees do matter
I own a Schwab Dividend Stock EFT (SCHD) in my Fidelity IRA that charges a 0.06% annual fee, or six basis points, which expressed as a decimal is 0.0006. Therefore, the annual fee on a $100,000 investment is a paltry $60.00 ($100,000 x .0006 = $60.00). (Because I am a DIY investor, I don't pay any additional fees.)
If it instead carried a 0.60% fee (or 60 basis points), the annual fee would be $600. A 1.0% fee (100 basis points) would be $1,000 per year, and so on. But remember, that fee would not be charged to me directly—it would be taken as an operating expense by Schwab, directly impacting total return.
Of course, investment growth is also measured in percentages. So, if you invested $100,000 in a fund with no management fee (good luck finding one) that earned 6% per year, you'd have $106,000 at the end of the first year. If the fund earned 6% but carried a management fee of 1% and you paid an advisory fee of 1 % (for fees totaling 2%), your actual earnings would be 4%, and your year-end balance would be $104,000 ($2,000 less).
Whether that's a bad thing depends on your perspective. If you think a 4% return for the level of risk you are taking and the advice you are receiving is reasonable in exchange for paying a 2% fee, then you're okay. However, if a comparable fund with a similar risk profile and performance only charges a 0.5% fee, and you pay no advisory fee, your net earnings could be 5.5% instead of 4%. On the same $100,000 investment, that's a difference of $1,500 per year.
That's not insignificant because fees compound just like earnings do—they just do it in reverse. You don't just give up $2,000 in the current year; you forfeit the compound growth that it may have had every year out into the future. That may not sound like a big deal, but they can add up and have a negative long-term impact on your investment returns.
Imagine if the $100,000 you have invested earned 6% year compounded for 20 years with no additional costs or fees. If you didn't save another dime, you would end up with about $320,714. If you paid total fees of 2% per year, you'd have almost a third less, $219,111. If the fund has an annual fee of 0.5%, you finish with $291,780.
Back in 2014, the Securities and Exchange Commission (SEC) published a paper on this topic. Look at this graphic from that paper—it illustrates the negative impact that fees in varying amounts can have over a long time.
So, it turns out that fees do matter, especially if you can get similar returns from a comparable investment at a lower management fee. This is why many people are turning to passively-managed index funds that tend to perform as well and sometimes better than their actively managed counterparts but with a lower expense ratio.
High fees have also been one of the problems with employer 401(k) accounts. Hefty fund fees and custodianship management (administrative) fees have cost unsuspecting employees tens and perhaps hundreds of thousands of dollars over their long saving and investing careers.
I stated previously that fees might not matter to you very much as long as "you're getting good value." In other words, "if your returns are good." This phrase seems intuitively correct. If you pay more and get more for your money, shouldn't you be happy?
The problem is that while some funds with high fees perform well, studies have shown that, generally, costly investments don't perform as well as less costly ones.
A 2010 study by Morningstar found that low expense funds outperformed the high expense funds in every asset class over every time period. Vanguard did a similar study in 2016 and also concluded that lower expenses and higher performance go together. So, if you take any two funds that benchmark the S&P 500, it's probable that the one with the lowest expenses will be the long-term winner.
If your expensive (high fee) mutual fund has performed well, better than a less expensive alternative, and is continuing to do so, you may do well to hold on to it. Just know that it's an exception to the rule (there are some).
Know your fees
If you don't know your advisor's fee, ask. You may also find it as a line item on your statement. It should also be part of the advisor's disclosure agreement (but it may be in the fine print, so to speak).
If you can't find it, and they won't tell you or tell you that it's a complicated calculation that you won't understand and not to worry about it, then take your money and run ( . . .well, walk—financial firms don't like people running through their offices).
Determining your mutual fund or ETF fee is also reasonably straightforward. It will be published in the fund's prospectus. Or, you can look up the ticker symbol, and Google or Yahoo Finance will list it as part of the fund information. Morningstar is another good source of information on mutual funds and ETFs. You may have to look closer at the fund information to see if it charges a front-end load fee.
Minimize your fees
If you want to use an advisor (most should), you shouldn't expect to get something for nothing. Wealth management firms have to charge fees, and I don't think that a regressive fee structure that charges a declining percentage of AUM for those with larger balances is unethical or wrong IF the investor with a lower account balance (who will pay a slightly higher percentage of AUM) receives a reasonable value from the services they receive.
The key is to understand what kinds of services you're getting and how often as compared with someone with a higher balance who is paying a lower percentage.
If investing is tedious and confusing or just plain scary to you, or you just have better things to do, hiring a financial advisor is probably a good idea. It will relieve you of the stress, free you up to do other things, help you make better investing decisions, and stay the course when the going gets tough (as it most certainly will). I prefer advisors who adhere to the fiduciary rule and won't charge you more than 0.50% of AUM (preferably less than .20 to .30%) or an hourly fee-for-service.
If you don't want to pay an advisor, then you can go the DIY route. If you are comfortable making your own investment decisions, it's relatively easy to build a low-cost portfolio that will accomplish basically what an advisor will do for you (especially since many use model portfolios for their clients anyway).
If you use low-cost index funds (mutual funds or ETFs), they will outperform most actively managed funds over long periods. There are plenty of examples of "lazy portfolios" (a term popularized by the "Bogleheads") that you can adopt as your strategy. (I wonder if there is a Boglehead bobblehead?)
If you go it alone, you'll need to develop an investment strategy that's right for you and decide on the right asset allocation of stocks and bonds based on your age and risk tolerance. Many model portfolios give you multiple versions along the spectrum of conservative (lower risk and return) to aggressive (higher risk and return).
A simple example of a conservative five index fund model portfolio from Vanguard, Fidelity or Schwab model for a retiree with average total fund fees of about .06% (.0006 as a decimal) might look like this:
- 25% – U.S. Intermediate-Term Bond Index Fund
- 25% – Inflation-Protected Bond Index Fund
- 25% – Short-Term Bond Index Fund
- 15% – S&P 500 Stock Index Fund
- 10% – International Stock Index Fund
Of course, there are lots of variations on this. For example, you could increase your stock or bond allocation or broaden it to include the entire US stock market, real estate, or commodities. Or you could tilt it more toward international or small-cap stocks.
But remember, if you invest by yourself, you will have to do your own research and make your own choices. You'll also have to decide what to do if anything when economic conditions change (e.g., rising or falling interest rates or inflation). However, there is a boatload of great free information available from blogs and books. You can even go so far as subscribing to a service such as Sound Mind Investing for model portfolios and fund recommendations for a small annual subscription fee that's not tied to the size of your account.
Can you be "fee free"?
You will probably never be completely free from fees. But if you understand them and make reasonable efforts to minimize them, that will go a long way in helping you maximize your returns over a long period of time.