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Understanding Investment Fees Is Critical to Success

Finally, investment management fees are being considered more widely. The popular media, government regulators and informed consumers are realizing just how important the cost of fees associated with investing is to investment success. Investment management fees are complex, and there is not much effort to educate investors, so they remain insidious in some cases. 

This fee triangle illustrates typical portfolio fees. Simple awareness of what types of fees are being charged can bring overall costs down.

Local Service Fees Charged for Investment Management

The first layer of fees is the most obvious: local investment management fees. Your trust company or department, registered investment advisor (RIA) or asset-based manager charges these fees, which are usually a percentage of the assets under management (AUM). For nonprofits, the typical competitive bid situation compares this cost between various vendors.

Portfolio Manager Fees Are Less Obvious

The second layer of fees is less obvious. These are third-party portfolio fees, and they are a component of mutual funds, hedge funds, exchange traded funds (ETFs), unit trusts, REITs and other managed products. Morningstar offers in-depth coverage of these fee ratios and costs. If your portfolio features separate managed accounts—individual stocks or bonds managed by a third-party—those management fees are included in this layer as well.

Fees in the second layer can be easily managed. The investment product marketplace features thousands of good choices. There is literally no reason to choose a high-priced product when there are hundreds of better-priced options. Pricing information on mutual funds, hedge funds, ETFs, unit trusts, REITs and other managed products should be compared before using. If you can’t find the cost for a product, seek another.

The Hidden Cost of Transaction Fees

This third layer of fees is most insidious of all. These are transaction fees, and they are often hidden in the trades. So, if your portfolio buys a thousand shares of stock, it pays a commission on that trade to someone. It will be reported on a confirmation, if you get one, but custodians might simply report the trade at “net” prices (after the trade costs). (For more from this author, see: 7 Ways Sales Commissions Hurt Investors.)

There can be huge differences among the level of transaction fees charged to each client. Volume can and does make a difference, but few clients see these fees without asking. Just because they aren’t obvious doesn't mean they aren't significant.

Fees Typically Come in Layers

Many traditional investment portfolios could have fees from all three layers, although some providers may feature just one or two. A stockbroker might recommend a stock or bond, and his payment would be through a transaction commission (layer 3). If he or she recommends a mutual fund, there’s a likely sales commission (layer 3), plus ongoing fund manager fees (layer 2). Buy a similar no-load fund directly from the fund family, and you’ll just pay layer 2 fees.In some traditional pricing models, bargains in layer 1 may be promoted while profits are made through a different one. For instance, front-end loads on mutual funds (sales commissions) might be replaced by an inflated and less obvious fund manager fee. With mutual funds, this is often accomplished through multiple share classes of the same fund. Importantly, it’s the total fees that matter to performance, not the particular fee scheme (although a scheme may matter for conflict of interest or other reasons). Most investment performance is tied to broad market averages instead of individual stocks and bonds, and the cumulative effect of layered fees directly impacts portfolio returns.

There have been many instances where layered fees inflicted a crushing blow to performance. The most offensive fees are often hidden in the darkness of layer 3 and don’t readily appear without knowledgeable and persistent persuasion. Still, shine some light on them and they’ll likely get better. That’s what fee transparency does for investors.

(For more from this author, see: How Cutting Fees Boosts Returns for Non-Profits.)