Costs And Fees Associated With Investments

What follows is a brief description of the various costs and fees that investors incur, be it due to transactions or an ongoing relationship.
  • Commission: this fee is expressed as a percentage of the product sold. When an investor buys or sells shares or bonds that are exchange-traded, he or she pays a commission expressed in dollar or percentage terms to a broker. In a mutual fund, the fund pays the commission.
  • Markup: for shares and bonds that trade over-the-counter (OTC), a market maker (essentially a middle man or jobber) buys shares from and sells share to investors, earning a markup or spread for his or her efforts. The design is to maintain an orderly market, but some bid-ask spreads are wider than others, to reflect a lack of demand or marketability that may stem from difficulties in valuing a particular security or product
  • Broker's Call Loan: when engaging in short sales or making purchases on margin, the investor borrows funds that charge an interest rate which must be disclosed.
  • Asset Management Fee:
    1. Mutual Funds charge a percentage of assets to manage a fund. The percentage rate or expense ratio is often a function of the risk level and trading activity associated with the investment being managed. As an example, a small capitalization growth mutual fund would, all else equal, have a higher asset management fee than a large capitalization value fund, where the portfolio manager or management team would patiently look for undervalued stocks that they would buy and hold in accordance with the fund's buy discipline. An important distinction with asset management fees that apply to mutual funds is that between active and passive management. An actively managed fund entails purchases and sales to satisfy the fund's objective; a passively managed or index fund seeks to replicate a specific segment of the financial markets (e.g., medium duration bonds or large capitalization core stocks, such as those in the Standard & Poor's 500 Index), holding, rather than trading, the assets which results in a lower fee. The premise of passive investment management is that markets are in the main efficient and that precisely because of the research and trading activities of active managers, no significant returns beyond what the market as a whole yields may be achieved over the long term.
    2. Investment Advisors and Financial Planners enter into relationships with their clients on a fee only basis. This means that they charge the client or place the client's money with (a) third party managers (separate account or structured portfolio of mutual funds) that charge the client a percentage of his or her assets under management, typically on a sliding scale where the percentage decrease at certain asset thresholds. In this example, the advisor or planner does not collect any fees from trading individual securities. Some advisors and planners "wear two hats," as it were, working on a fee basis, but also collecting, rather than offsetting, a commission where a product implementation (purchase) may be warranted
  • Hourly billing: some financial planners use this type of fee arrangement when working with clients, setting a rate that is a function of the area in which they conduct business, as well as the scope of the engagement.
  • 12b-1 fee: the mutual fund charges this expense to pay for its marketing and distribution costs. It may not exceed 1% in accordance with SEC regulation. The fund pays the 12b-1 fee.
  • Load: a load is a percentage of assets that the investor pays, subject to legal guidelines in a mutual fund. This type of fee applies to open-end mutual funds. Depending upon the share class of fund that the investor selects, the fee may be paid at the time of purchase in an A share (a front end load or up-front sales charge) or on a trailing basis as an incentive to hold, rather than trade, a fund for a certain length of time beyond which the investor would pay nothing, in what is known as a B share (a back end load or contingent deferred sales charge). A typical holding period would be seven years, during which the investor would incur a charge for trading the fund; the earlier in that seven year window that the trade would occur, the higher the percentage would be. In a C share, a higher 12b-1 exists and contingent deferred sales charge is in force for one or two years. Some funds carry no sales charge (no-load mutual funds). The shareholder pays the load.
  • Institutional Share Class Mutual Funds: these may be part of large retirement plans or brokerage wrap programs. Known also as Class I, Y or K shares, they charge no load or 12b-1 fees. Class R shares are used in retirement plans, charging a lower 12b-1 fee to help defray recordkeeping costs.
  • Rights of Accumulation (ROA): a retroactive application of reduced breakpoint sales charges based upon the accumulation of assets in the fund.
  • Letter of Intent (LOI): the investor in the mutual fund signs a letter of intent to purchase a predetermined quantity of mutual funds over typically a one year period. Satisfaction of this agreement results in a lower sales charge. Failure to honor it results in the higher sales charge being applied retroactively to contributions made from the time that the letter of intent was executed.
  • Purchase, Redemption and Service Fees (custody, wire transfers, small accounts): typically the shareholder pays these fees.
  • Transfer Agency, Administrative, Registration, Professional Services (audit, legal), Custodial, Board of Directors fees and expenses: the fund pays all of these fees.
  • Mortality and Expense Risk Charge (M&E): these fees apply to annuities, both fixed and variable, as well as life insurance. They are the fees that pay for the insurance guarantee, sales commission and administrative costs of the annuity contract. These can range from between 1 and 3%. In a variable annuity, these are in addition to the asset management fees in the subaccounts
  • Surrender Charge: applies to insurance products, which include life insurance and annuities. The fee works like a contingent deferred sales charge on a Class B share mutual fund. If an annuity is surrendered during a window of typically seven years, the fee will apply. The earlier the surrender, the greater the fee charged, a fact which motives longer term investment in a fixed or variable annuity.
  • Wrap Fees: life insurers offering annuities as 401(k) plan options charge this sort of fee, which includes the annuity's mortality and expense risk fee, plan services fee and asset management fee. The greater the amount of assets under management, typically, the lower the wrap fee that is charged.
  • Hedge Funds: employing a multitude of trading strategies to capture return in excess of the markets (termed alpha - Q), these arrangements are distinguished by their fee structure, which consists of a percentage of assets under management and a percentage of the earnings above a threshold, commonly referred to as the "carry." A typical cost structure would be "two and twenty," which means that the hedge fund manager charges the investor 2% of assets under management and 20% incentive fee, collected only if the fund's net asset value at year's end is greater than what is was at the year's beginning. Should the fund in a subsequent year fail to equal or exceed those gains, then the fee would not be charged, as the manager failed to surpass the "high watermark." The charge for assets under management would still apply, however. This dual fee structure varies by manager as a function of the complexity of their strategy and the types of assets that they manage.
  • Private Equity: refers to securities that are privately purchased and not publicly traded. The four common strategies subsumed under this rubric are the financing of start-up companies known as venture capital, public companies repurchasing all of their stock to become private, with the assistance of leverage, known as leveraged buy outs (LBOs), a mix of private debt and equity financing known as mezzanine financing (a type of bond with an equity sweetener such as a warrant) and investment in troubled private companies, known as distressed debt investing. The fee structure here is, for the most part, like that which applies to hedge funds. There are some differences,
    1. LBOs: in addition to the annual management and incentive fees, the buyout firm may charge to the corporation that it has helped to take private, a fee of up to 1% of the company's total selling price for the arrangement and negotiation of the transaction.
Required Disclosures

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