I've discussed the various compensation models that financial advisors use. An understanding of these models is clearly helpful when trying to select an advisor or create your personal finance team, but what about the true impact to you and your portfolio's performance? Do you feel that you have a clear sense of what your investment costs amount to? Are you using a full-service broker or insurance agent to help you invest? If so, you're almost certainly paying too much.
Let's examine mutual funds. These funds are used heavily by large brokerage firms because of the high fees that are generated by them and the ease in which brokers can allocate client accounts. Most broker-sold mutual funds come with a variety of commissions and fee's that are often overlooked by the client. With exception of the trading costs which are listed on your brokerage statement, these other fees are not reflected seperately on the brokerage statement. As a result, many investors are clueless as to the true amount they are spending. Here are some of the most common additional mutual-fund fees:
Front-end loads: These are commissions to investment intermediaries as sales commissions upon the purchase of the mutual fund. These sales charges are not part of a mutual fund's operating expenses. In mutual funds with separate classes of shares, these fees are found within Class A shares.
Back-end loads: These sales charges are used with mutual funds that have share classes, and are assessed upon sale of the mutual fund. These commissions are paid to a financial intermediary as a sales commission, and like front-end loads are not included in a fund's operating expenses. In mutual funds with separate classes of shares, these fees are found within Class B shares.
Level-loads: These sales charges are not assessed at purchase or sale, but rather applied annually as a fixed percentage of a mutual fund's average net assets. Unlike front-end and back-end sales charges, these 12b-1 fees are included in a fund's operating expenses, and are present in class C shares of a mutual funds that have separate classes of shares.
12(b)1 fees: The annual marketing or distribution fee of a mutual fund paid as a reward to selling fund shares. There are many critics of these particular fees as it is currently believed that commissions paid to salespersons have nothing to do with enhancing the performance of the fund -- the initial premise for the creation of this type of fee.
Management and administrative fees: to compensate the funds investment advisor for investment portfolio management and administrative fees not included in the funds' "other expenses" category.
Trading costs: the cost of buying and selling securities through your broker. These fees can range significantly from broker to broker.
While I like to give advisors the benefit of the doubt, I am constantly surprised that most stockbrokers, so called 'wealth advisors'/'financial advisors' with large brokerage firms, and insurance salespersons are unable to provide clients with a clear picture of how much they are paying in total investment costs. I suspect that the reason these individuals are unable to provide such detail is that they probably don't know the answer, and may not have the adequate information information accessible to provide an reasonable response. To calculate the true investment costs paid, one would need to review the investment prospectus for every product in a portfolio, calculate the total cost for each, add sales fees based on each transaction in the account, and then include the asset-management fee charged separately (and usually on a quarterly basis).
All of these fees seriously degrade your investment performance. Take an initial $10,000 investment in a mutual fund that has an 8% annual return on investment, a front-end sales charge of 3% and annual operating expenses of 1.25%. Lets say that you pay a $60 commission to purchase the fund and you pay your wealth manager 1% of assets under management, per annum, for investment management services.
So, you would pay $300 in commission to purchase the fund and operating expenses of $131 throughout the year. At the end of the first year, assuming an 8% return on investment, you would be left with an account value of $10,345. But we didn't deduct the $60 transaction charge nor the $100 in annual advisory fees paid on this particular account. The net result is $10,185 or a 1.85% return on invested capital. I'm pretty sure we can all think of better ways to generate 1.85% on our money without giving away over 6% of our 'theoretically earned return' to do so. The math gets even worse when you consider that transactions costs, as well as investment management fees are generally deducted in advance (quarterly, in advance, for investment management fees).
Mutual fund fees are likely only one of the myriad of ways you are overpaying, however. Have you purchased whole-life insurance policies or annuities with their incredibly high mortality expenses and surrender penalties? What about wrap fees? The list goes on and I'll certainly tackle these items in a future post.
So how do you invest with more prudence? For starters, I'm not suggesting that all mutual funds are bad, in fact many of them perform quite well. Be sure to review prospectuses carefully and fully understand how fees are being assessed. If you are managing you own money, look for low cost funds. Vanguard offers funds with an average expense ratio of 0.19%, or 83% less than the industry average of 1.11% (source), and do not come with 12(b)1 fees. If you are looking for more professional guidance and a customized and tactical approach to fit your needs, be sure to work with an independent and fee-only investment advisor who will be sure to keep your portfolio low-cost and true to its intent.
Jason M. Gilbert CPA/PFS, CFF
Jason Gilbert is Managing Director of RGA Investment Advisors LLC. He has over 10 years of experience in investment advisory, including portfolio construction, financial strategy, and advanced planning for high-net worth and institutional clients. He maintains an extensive background in both forensic accounting and personal finance, and serves as a fiduciary and trusted partner to his long-standing clients.