Firms are often very discreet about the cost of their services and various offerings. Accordingly, one of the more problematic elements of the entire investment process is a lack of cost transparency, and at worst, costs that are really concealed. An unfortunate reality of many investments is that the fees are either not clear or not fully evident. Read on to find out why fees are kept hidden and how you can find and avoid them.
Tutorial: Mutual Funds
Most mutual funds are pretty expensive to run. There are managerial fees, so-called soft dollars (paid to service providers), compliance fees and marketing expenses. Ultimately, these are all paid for by the investors. This means that as much as 3-6% of what investors could hypothetically be earning on their investments is going out the window. Investing in annuities, variable annuities, hedge funds, commodity funds or private equity can skyrocket those expenses two or threefold. Unfortunately, in many instances, these costs are not visible to investors entering these investments. It is also important to understand generally how the mechanics of cost work. For instance, small-cap stocks cost a lot more than large caps to trade. This does not mean that you should seek out a fund that only trades large caps, but these are things that investors should be told and really need to know before they invest.
Another thing that can lead to increased costs is that some funds and brokers are also guilty of some degree of churning, even if it is not so extreme as to constitute mismanagement. Active management is one thing, but funds may drive up costs with transactions that do little or nothing to help the investors.
There is substantial literature on the hidden cost of mutual funds, such that it is really essential to know what you are paying and whether there are better and cheaper alternatives out there. The industry sells performance and does not talk much about cost. The reality is that the two go hand in hand; good investment performance is eroded by high costs. Of course performance is important, but what you earn from your investments is performance minus cost. It is unrealistic and dangerous to view the process any other way. (For related reading, see Break Free Of Fees With Mutual Fund Breakpoints.)
Misallocation the Enemy of Most Investors
Both empirical research and extensive anecdotal evidence reveal that many investors are misallocated. For example, in 2008, the German newspaper Die Welt conducted a survey together with the V-Bank and found a remarkable array of unnecessarily risky, undiversified portfolios. These are not tailored to specific client needs and preferences, despite the industry hype. This scenario also leads to complex and expensive portfolios full of bits and pieces that do not provide the investor with the appropriate exposure to the right assets.
Many banks and brokers like to sell hedge funds and certificates. While both these investments have a legitimate financial place in many portfolios, the fact remains that they are particularly lacking in transparency. Low transparency can often be associated with high costs.
It is also very easy for investors just not to worry about cost if the investments seem to be doing OK. One can argue that as long as the bottom line is nicely in the black, all appears to be well. But that is not always true. For example if a cost-laden portfolio is earning you 6% a year, a more efficient one might earn you 9% or more. Even a 1% difference in an annual rate of return can make all the difference between an early or comfortable retirement and a constant struggle into old age. (For more insight, see A Guide To Portfolio Construction.)
If You Can't Beat Them, Make It Cheaper
The investment literature shows that on average, managers who try to beat the market indexes generally do not succeed over time. This means that investment success really depends on reducing cost. After all, even those select few brokers and fund managers who really do beat the market will do so only by a couple of percent over time. Over the long run (durations of 15 to 25 years) few, if any, outperform their respective benchmarks. You are more likely to achieve benchmark-beating returns if you lower investment costs by that same couple of percentage points.
If you add up redemption fees, brokerage fees, back-end load fees, management fees, inactivity fees, 12b-1 fees, transfer fees, minimum equity requirement fees, commissions, the cost of limit orders, and sundry overheads like consultancy costs, bookkeeping and accounting and even more, it is not difficult to see that they can constitute a major problem. The simple fact is that costs determine whether your entire investment process is viable. (For more, read Benchmark Your Returns With Indexes.)
Balance and Fairness
This does not necessarily mean that all investment fees/costs are unjustified, but you must be getting your money's worth. Ask yourself: Could you invest elsewhere and do better? Funds that are specialized, such as infrastructure or resources, and are managed sensibly and actively may be worth an additional cost; if a fund is simply trying to beat a standard index, it is probably not worth shelling out for. This is part of the reason why index funds are so heavily promoted by experts, and neglected with equal enthusiasm by financial professionals who make a living on commissions. (For more insight, see Index Investing: Index Funds.)
In short, good advice and useful skills are worth paying for and some funds certainly justify the cost.
Run a Low-Cost Operation
One way of lowering the costs of running a portfolio is to avoid mutual funds altogether and only purchase individual stocks and bonds. Your objective would be to have an efficient portfolio with low and totally transparent costs. There are indeed firms and brokers out there whose stated aim is to keep costs down and make sure that investors know exactly what they are getting and paying. Some also try to do no more than match the market on the way up and beat it on the way down. This can be done through very careful asset allocation and portfolio management. There may not be all that many firms operating in this manner, but they do exist and are well worth taking the trouble to find.
Complicated, excessively busy portfolios eat into returns and can cost a fortune in lost profits over the long run. The first step to getting it right is to understand exactly what it costs to run your investments and then to make them as simple and transparent as possible. Given the difficulty or even impossibility of beating the markets themselves, keeping costs down is one of the major means of winning the game. Sadly, given the nature of the industry, it is not an easy game to play and it's even harder to win.