When it comes to managing their investments, many people are simply unaware of what they’re paying. We are often tempted to turn a blind eye to fees, especially when feeling uncertain about how things work or even the questions we should be asking. Thus, in this article, I’d like to explain some of the commonly overlooked fees that are involved in investing. Whether you are happy to pay for the services of a trusted advisor or unhappy with your situation, you should certainly know about how fees work and what they are. As I always say, knowledge is power!
The most straightforward fee you may encounter is the annual asset management fee. This is a fee charged directly out of the account and is often expressed as a fixed percentage of assets under management; for example, your advisor might charge 2 percent per year. Depending upon the arrangement, it is most likely to be charged quarterly in advance. However, the annual management fee is not a given: some advisors charge all clients a flat annual fee and some work only on a commission basis, in which a fee is charged on each transaction, while others use a combination of both depending on the particular client’s situation.
For example, a client who wants an actively managed, diversified portfolio may find that most potential advisors will quote a flat fee. This is because such accounts require consistent re-examination, careful trading, rebalancing, tax harvesting, etc. On the other hand, if your accounts have the same mutual funds or investments that they did two years ago, you should probably not be paying an annual management fee.
If your account is invested in mutual funds, you may also be subject to two additional fees. The mutual fund’s annual expense ratio is the most commonly known, and it covers the mutual fund’s fixed and ongoing expenses, such as portfolio manager salaries, customer service reps, and the printing costs of prospectuses and marketing materials.
While it might sound mundane, you should always be aware of your mutual fund expense ratios because they can vary widely and because these fees are not listed on your account statement or trade confirmations. An easy way to learn about expense ratios is to visit Morningstar, where you can type any fund’s name or symbol into the search box and find basic information, performance numbers, and a fee report. It’s a great, easy-to-use tool that will really help you learn about your investments!
Once you know a given fund’s expense ratio, you need to take into account several variables before determining whether it’s reasonable. Actively managed mutual funds typically carry higher fees than index funds, and, generally speaking, international or emerging market funds are more expensive than your average S&P 500 fund. A good advisor can help you balance fees by constructing a portfolio that meets your investment objectives while keeping fees at reasonable levels. It may sound daunting, but don’t be reluctant to ask about this! Overloaded fees can eat away at your portfolio’s value over the long run, so it’s important that you understand your advisor’s reasoning for building your portfolio in a particular way and feel comfortable with your account fees.
Most people think that the expense ratio is the whole story when it comes to mutual funds. However, mutual funds also charge fees for brokerage commissions and trading expenses incurred. Of course, a mutual fund’s trading fee structure is likely far lower than anything an individual could command, but more trading still equals more fees. In order to find out about these ongoing variable expenses, you can’t rely on the expense ratio: You have to look at the fund’s annual Statement of Additional Information (SAI). This information is not required to be mailed to you like the fund’s prospectus and can be difficult to quantify, even when using information available online.
As you can see, the possible fees can add up quickly. For example, suppose you are paying a 2% asset management fee, 1% in expense ratios, and trading fees (as noted in the SAI) of roughly 1%, your breakeven requirements in terms of performance are suddenly a lot higher than you may have anticipated (please note that these numbers are fictitious). There is nothing wrong with paying fees, but you need to know what you’re getting in return.
Now, whether a given fund’s overall fees are reasonable is a question that is best resolved through a discussion with your advisor, but you should not be afraid to ask about total costs.
I can’t stress enough the importance of understanding the asset management fee, expense ratio, and additional expenses from the SAI. I often see potential clients who rolled over their 401(k) into an IRA and who pay an annual asset management fee to their advisor… but haven’t seen a change in their portfolio in well over a year. Or those who have left money in an old 401(k), unsure of their real fees and constrained by limited investment options. These stories are repeated all too often, and with a little bit of diligence you can avoid such traps and get your assets into an investment program more suitable for your needs.
Now, you may think that as long as returns are meeting your expectations that total costs don’t really matter. I wish it was that easy, but unfortunately relying on high returns is not enough. Most importantly, you need to consider how much risk you’re taking on and whether the asset management fee and portfolio strategy make sense. If you’re paying for active management, you should be getting it, and any portfolio should be grounded in an understandable investment philosophy. Finally, remember that you pay fees both in good markets and in bad, so trying to establish some downside protection and risk management strategies are important issues relevant to both performance and cost.
When it comes to fees, we all know that we need to pay for advice and asset management, but we’re sometimes afraid to ask about costs. A good advisor will always talk to you about his or her management fees and mutual fund expense ratios and won’t be afraid to investigate lower-cost alternatives. Indeed, there are many ways to build cost efficient portfolios; for example, instead of building a diversified portfolio consisting only of mutual funds, you might add a mix of mutual funds, Exchange Traded Funds (ETFs), and individual stocks.
In the end, of course, proper asset management comes down to the big picture. It’s about building the portfolio that is right for you, which should take into account not just cost, but the risk you’re willing to take on, whether you’re seeking active or passive management, and whether there are other services that you receive in exchange for the fees you pay. It’s critical that you understand and are comfortable with your management plan, and the best way to ensure that is through education. With this primer on fees and fee structures, you have taken the first step in understanding some of the important details about the management of your accounts, which gives you the power to steer your portfolio management in the direction that is right for you.
If you are seeking detailed information about rolling over your 401(k) or about managing your IRA, I highly suggest downloading my free eBook, “10 Tips You Need to Know About Your IRA Rollover”. This short book is packed with critical information that will help you make the right decisions about your retirement savings.
Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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