Rule 1A in investing is “Know what you hold, and know why you hold it”. Many investors will admit to not fully understanding what’s in their investment accounts, or how much they’re paying in fees. To their credit, it’s not always straightforward. It is, however, crucially important not only to understand how much it’s costing you to invest, but how those costs impact your portfolio’s return over time.
Stocks & Bonds
We first have to understand how we are being charged for individual investments. The most basic investment holdings we are accustomed to hearing about are stocks and bonds. When we buy these investments we are essentially loaning the company our money in hopes that they will use it effectively to grow the value of the company and provide us with a return. The only fees associated with stocks and bonds are when you are buying and selling them. Typically, a small transaction fee is charged when buying or selling these securities on an online platform. These transaction fees range from a couple of dollars to free depending on the platform that you use. It’s important to remember every dollar counts when it comes to investing, so switching to a platform with smaller or no transaction fees is worth your consideration if you’re a fairly active trader.
Outside of transaction fees, stocks and bonds have no other fees associated with them. This is noteworthy, as almost all other investments carry some sort of ongoing expense as they grow within your portfolio. In this way stocks, and bonds are cheap from an ongoing cost perspective relative to other investment types.
Index & Mutual Funds
The next investment categories to understand are index and mutual funds. Let’s start by defining and differentiating them. Index funds, sometimes referred to as Exchange-Traded Funds or ETFs, are essentially bundles of various stocks. These bundles are meant to provide you with investment exposure to specific areas of the market. For example, you can buy a technology index fund which is meant to provide you with the returns of the technology sector. Index funds offer a lot of benefits in that they create an easy path towards diversification, and allow you to target specific areas of the market.
Mutual Funds are similar in that they are also bundles of investments, but the key difference of mutual funds is that they are actively managed. Meaning behind every mutual fund is a team of professional investors using your money pooled along with everyone else’s to buy and sell investments. Their objective is to provide the investors with higher returns. This is different from index funds which are passively managed, meaning there’s no one behind the scenes. Herein lies the defining difference between index and mutual funds. Because mutual funds have a team of professional investors behind them, they are theoretically a premium investment option. Therefore, mutual funds tend to charge you more to those who choose to invest in them.
Expense Ratios
So how are these funds charging you? In addition to potentially paying a transaction fee when buying/selling these funds, index and mutual funds charge what is known as an expense ratio. The expense ratio is what you pay that fund on an annual basis, and is based on the amount you have invested in the fund. For example, if a mutual fund has an expense ratio of 0.80% or 80 basis points and your investment value in that mutual fund equals $1,000. Then it will cost you $8 to hold that mutual fund for the year. This $8 is deducted either annually or on a given schedule depending on the fund you are invested in.
Expense ratios tend to be the most commonly overlooked cost by the average investor, and yet they can have a profound impact on your portfolio over time. Without getting too far into the debate of mutual funds vs. index funds, understand that every dollar deducted from your portfolio each year is a dollar that is no longer earning you compound interest, and over a longer period that missed compound interest can really add up.
Let’s look at an example where you have $100,000 in an investment account and you are trying to decide between a portfolio made up of mutual funds vs. index funds. You are hypersensitive to investment fees so you choose to invest your money in several index funds with an expense ratio of 0.20%. Let’s say that over the next 20 years your index funds return a steady 7% per year. At the end of the 20 years you would have approximately $372,000. Let’s say instead you had invested in mutual funds with an expense ratio of 0.50%. You would instead end up with approximately $352,000 after the same period. That’s a $20,000 difference in your account solely attributable to the slight difference in expense ratios.
It should be noted that proponents of mutual funds will immediately make the argument that mutual funds will provide better returns, even with higher expense ratios, because of their active management. In essence, you’re paying a premium for active management and that premium will be worth it in the end. However, the data suggests that in actuality mutual funds are hit and miss. The jury is still out on whether passive or active management has performed better over the long-term. When it comes to choosing between these funds your biggest concern should be understanding what you’re getting for the expense ratio that you’re paying.
Custodial & Advisory Fees
Finally, we arrive at the third and final layer of fees. In addition to expense ratios and transaction costs, you may be paying a custodial or advisor fee. Starting with a custodial fee, these are fees typically associated with employer sponsored retirement plans, and like an expense ratio, they are typically based on the amount of assets held within your individual account. Morningstar estimates that average 401k fee ranges from 0.36% to over 1% per year depending on the size of the plan. This fee is on top of whatever you are paying as an expense ratio for the investment funds in your account. Keep this in mind the next time you change jobs, and are wondering what you should do with your old 401k. Rolling it into a Rollover IRA can often save you that annual custodial fee, which will add to your gains over time.
Financial advisor fee structures have begun to change in recent years as the result of more emphasis being put on financial planning over investment management. However, it is still extremely common for advisors to charge an expense ratio-like fee based on the amount of assets they manage for you. Typically, a financial advisor’s fee will be the highest from an absolute dollars standpoint. Why? Because in theory they should be adding the most value to your overall financial well-being by choosing the appropriate investment strategy and providing valuable planning advice. Remember, you should only be paying a financial advisor if you feel you are getting greater or equal value to what you are paying them. A good financial advisor will make you aware of each of these fees mentioned above, and will even work to minimize the fees associated with your accounts.
Understand the Impact
This list of investment types and their associated fee structures is not all-encompassing, but it does lay out the basic and most common fees investors are charged. Understanding the different fees associated with your investments and accounts can be the difference of significant sums over the course of years. To avoid being over-charged use some guiding principles.
- An expense ratio of 1% or more for a fund is relatively high, whereas 0.20% or lower is relatively low.
- If you’ve left a job consider rolling over your old 401k to avoid annual custodial fees.
- Only work with an advisor that you feel provides equal or more value than what you are paying them.
Every dollar you’re able to save in fees is a dollar that remains invested and gaining compound interest. That’s worth paying attention to.
