All investments carry costs-- real costs, not merely the opportunity costs of an investor choosing to forego one asset in favor of another. Rather, these costs and comparisons s are not that dissimilar to the costs that consumers examine when shopping in a retail store or buying a car.
- Unfortunately, many investors ignore these critical investment costs, often because they can be confusing or obscured by fine print and jargon. But they don't have to be. Here are 4 strategies to keep in mind before you invest that can save you from headaches later on. The different types of investing costs
- Why costs matter
- Whether or not higher cost investments are worth it
- Ways to minimize these costs
Know the Types of Investing Costs
Different investments carry different types of costs. For example, all mutual funds – one of the most common investment instruments--charge what’s called an expense ratio, which is a measure of what it costs to manage the fund expressed as a percentage. It is based on the total assets invested in the fund and is calculated annually. This fee is typically paid out of fund assets, so you won’t be billed for it, but it does come out of your returns. That means if the mutual fund returns 8% and the expense ratio is 1.5%, you’ve really only earned 6.5% on your shares.
There are two problems with a high expense ratio. First, a higher portion of your money is going to the management team instead of your savings. And second, the more money the management team charges, the more difficult they make it to match or beat the market’s performance. This makes intuitive sense. Expense ratios, like a leak in a bathtub, slowly drain some of the assets. Therefore, the more money management takes out in the form of fees, the better the fund must perform to earn back what’s been deducted.
Ironically, many higher cost funds claim they’re worth the extra cost because they enjoy stronger performance. However, they’re only making this strong performance more difficult to achieve with the higher fees.
Moreover, in some cases these fees help pay for marketing costs. This means that you are paying managers to promote a fund to other potential investors. This particular cost is called a 12b-1 fee. Paying it essentially means you’re bankrolling the marketing department.
But wait, there’s more!
Be mindful of annual fees and custodian fees, too. Annual fees are often low, about $25 to $90 a year, but everything adds up. Custodian fees usually apply to retirement accounts (e.g., IRAs) and cover costs associated with fulfilling IRS reporting regulations. You can expect to pay anywhere from $10-$50 per year.
Some mutual funds include other costs, like purchase and redemption fees, which are a percentage of the amount you’re buying or selling.
Also, be aware of loads and commissions, which are separate from the expense ratio. Loads can be front-end or back-end. A front-end load is a fee charged when you buy shares, a back-end load is a fee incurred when selling. This money goes straight to the investment company. Commissions are essentially brokerage fees that are paid to the broker for their services.
As you can see, the financial world has not made it easy to untangle all of these complex and often hidden expenses. However, the U.S. Securities and Exchange Commission (SEC) may take steps to clarify these costs for investors. In an effort to protect retail investors, the SEC, in its 2018 priority list, indicated its intent to “Focus on firms that have practices or business models that may create increased risks that investors will pay inadequately disclosed fees, expenses, or other charges.” In other words, the SEC plans to take aim at firms that engage in practices like receiving compensation for recommending specific securities, ignoring accounts when the assigned manager has left the firm, and changing fee structures from commission-only to a percentage of client assets under management.
While the SEC plays a valuable role in safeguarding investors, the best defense against excessive or unwarranted fees is doing careful research and asking plenty of questions. Taking the time to understand what you’re paying is critical because fees, over the long-term, rob investors of their wealth. Let’s look at how this happens.
Why Broker Investing Costs Matter
Investors are not focused on boring fees, but on making money with annualized returns. However, achieving this goal requires a concerted effort to minimize costs.
Part of the problem is that fees almost always appear deceptively low. An investor might see an expense ratio of 2% and dismiss it as inconsequential. This is an understandable mistake. A number as low as 2% does, in fact, appear miniscule. But it’s not. Why? A fee like this doesn’t reveal to investors the dollars they’ll be spending, and more importantly how those dollars will grow. A percentage is less threatening than a dollar figure. Moreover, if a first-time investor chooses an investment that carries a high fee they may be setting themselves up for a lifetime of unnecessary costs. The reason? Anchoring bias.
We’ve all experienced anchoring bias. Simply put, everything is relative. This means that if our first exposure to investing involves excessive fees, we may view all subsequent expenses as low even though they are, in fact, high.
However, the strongest argument against high fees is the steady but powerful erosion of wealth over decades. Just as compounding delivers growing returns to long-term investors, high fees do exactly the opposite; a static cost rises exponentially over time. Here are some examples.
Suppose you have an investment account worth $80,000. You hold the investment for 25 years, earning 7% per year and paying 0.50% in annual fees. At the end of the 25-year period you’ll have made approximately $380,000.
Now, consider the same scenario, but with one difference; you aren’t paying attention to costs and you hand over 2.0% annually. After 25 years you’re left with approximately $260,000. That “tiny” 2.0% cost you $120,000.
The takeaway: Little percentages cost you big dollars over the long-term. Mutual funds and brokerage firms rarely spell out examples like this for investors. Therefore, it’s up to the individual to do the math.
Now, imagine that an advisor, or even a friend tells you that a mutual fund, while pricey, is worth the expense. He tells you that while you’re paying more, you will also get more in the form of a superior annual return. Perhaps now 2% is worth it, right? Wrong. Here’s why.
A 2014 study concluded that, on average, lower-cost funds tend to produce better future results than higher-cost funds. In fact, that same research found that the cheapest equity funds outperformed the most expensive ones across 5-, 10-, 15-, and 20-year periods. Again, this is easy to believe. As mentioned earlier, the more money coming out of the fund in the form of fees, the better the fund must perform to overcome the loss of capital. That is, the money that could be working hard for investors in the market is just sitting on the sidelines (i.e., in the manager’s pockets).
This finding has been proven time and time again. Consider similar research from Morningstar, which found, “Using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015. For example, in U.S. equity funds, the cheapest quintile had a total-return success rate of 62% compared with 48% for the second-cheapest quintile, then 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile.”
What’s the message? “The cheaper the quintile, the better your chances.” Interestingly, this finding was consistent across various asset classes. That is, international funds and balanced funds all showed similar results. Even taxable-bond funds and municipal bond funds exhibited this characteristic of low costs being associated with better performance.
Brokerage fees come in all shapes and sizes. They include:
Account Maintenance Fees: This is usually an annual or monthly fee charged for the use of the brokerage firm and the included research tools. This fee is occasionally tiered. Those who want to use more robust data and analytic tools pay more.
Sales Load: Some mutual funds include a "load" or a commission paid to the broker who sold the fund. Be wary of these charges for two reasons. First, many mutual funds today are "no-load" and are therefore cheaper alternatives. Second, some brokers are unscrupulous and will push funds with larger loads to pad their revenue.
Advisory Fee: This is also sometimes referred to an a "management fee." This cost is a percentage of the total assets the investor has under the broker's management. This fee is the cost of whatever expertise the broker brings to the table in the form of wealth strategies.
Expense Ratio: As discussed earlier, this is a fee charged by those managing the mutual fund.
Commissions: These are common and they add up fast. Commission fees are the cost of executing any buy or sell trade. This payment goes directly to the broker. This cost usually ranges from $1 to $5 per trade and, in some cases, will be waived if the investor reaches an account minimum. Occasionally this fee is calculated as a percentage of the value of the trade.
Remember that full-service brokers who provide complex services and products like estate planning, tax advice and annuities, will often charge larger fees. As a rule-of-thumb, this fee is usually 1-2% of the value of the assets managed.
The burden of expensive fees becomes greater over a longer period. Therefore, young investors just getting started face a bigger risk because the total dollars lost to costs will grow exponentially over decades. For this reason, it’s particularly important to pay attention to costs in accounts that you will hold for a long period of time.
Unfortunately, even cost-conscious investors can get saddled with undue expenses at the hands of opportunistic investment advisors. Problems like this are so common that President Obama initiated a new rule to curtail such practices. Simply put, the rule mandates that financial advisors and brokers managing retirement accounts provide advice that’s only in their client’s best interest. It’s telling that the expectation of sound investment advice can only come when it’s required by law. Essentially, the law is designed to prevent dishonest brokers from advocating investments selected on the basis of the commission they’ll receive rather than on the basis of what’s most appropriate for the investor’s long-term goals.
Are Expensive Investments Worth it? Active versus Passive Management
At its core, this question is about active versus passive management. Passive management describes investments like mutual funds that are designed to replicate market indexes like the S&P 500 or the Russell 2000. The managers of these funds only change the holdings if the benchmarked fund changes. Passive management seeks to match the market’s return.
In contrast, an active management strategy is a more involved approach, with fund managers making a concerted effort to outperform the market. They’re not happy with simply matching the return of the S&P 500; rather, they want to make strategic moves that seek to exploit the value of unrecognized opportunity in the market.
Active and passive funds carry different costs. The average fee for actively managed funds in 2016 was 0.82%, whereas passive mutual funds averaged just 0.27%. Moreover, as the total amount of assets in an actively managed fund decreases, these funds, in general, raise the expense ratio. As one study from ICI Research determined, “During the stock market downturn from October 2007 to March 2009, actively managed domestic equity mutual fund assets decreased markedly, leading their expense ratios to rise in 2009.” This finding underscores an important truth: Expense ratios are often not tied to performance. Instead, they’re tied to the total value of assets under management. If the assets decrease – usually due to poor performance – the managers will simply raise their prices.
Some investors will argue that “you get what you pay for.” In other words, while an active fund may charge more, the higher returns are worth the expense because investors will earn back the fee and then some. In fact, these advocates for active management occasionally have the annual performance to back up such claims. There is, however, often a problem with this assertion: survivorship bias.
Survivorship bias is the skewing effect that occurs when mutual funds merge with other funds or undergo liquidation. Why does this matter? Because “merged and liquidated funds have tended to be underperformers, this skews the average results upward for the surviving funds, causing them to appear to perform better relative to a benchmark,” according to research at Vanguard.
Of course, there are some actively managed funds that do outperform without the help of survivorship bias. The question here is do they outperform regularly? The answer is no. the same body of research from Vanguard shows that the “majority of managers failed to consistently outperform.” The researchers looked at two separate, sequential, non-overlapping five-year periods. These funds were ranked into five quintiles based on their excess return ranking. Ultimately, they determined that while some managers did consistently outperform their benchmark, “those active managers are extremely rare.” Moreover, it is nearly impossible for an investor to identify these consistent performers before they become consistent performers. In attempting to do so, many will look at previous results for clues on future performance. However, a critical tenet of investing is that past returns are no predictor of future gains.
The underlying reason for underperformance in most actively managed funds is that practically no one is able to consistently choose well-performing stocks over the long-term. One study, for example, found that “less than 1% of the day trader population is able to predictably and reliably earn positive abnormal returns net of fees.” Active managers are no better. In fact, this figure of 1% is eerily consistent with other research that examined the performance of 2,076 mutual funds from 1976 to 2006. Those results showed that fewer than 1% achieved returns superior to those of the market after accounting for costs.
Moreover, the challenge of beating the market is growing. A multi-university study determined that prior to 1990 an impressive 14.4% of equity mutual funds outperformed their benchmarks, but by 2006 this figure had dropped to a miniscule 0.6%. Consider these figures when asking if an active management solution is the right move.
Ways to Minimize Investing Costs
Now that you know the importance of minimizing costs, it’s time to learn how to do it. Here, we look at a few simple ways to grind costs down and making it easier to build wealth.
This is the easiest advice you’ll ever hear. Fortunately, it’s also the best. The more you move money around, the more costs accrue. As discussed above, there are fees and charges associated with buying and selling. Like a pail of water passed from one person to another, each successive hand-off causes a little spill. Moreover, buy-and-hold strategies yield better returns than those based on frequent trading. As the Financial Times reminds us, “Over 10 years, 83% of active funds in the U.S. fail to match their chosen benchmarks; 40% stumble so badly that they are terminated before the 10-year period is completed.”
Consider Tax Implications - This is the most ignored aspect of investing costs. It's also the most complicated. Even seasoned investors find it beneficial to get help from a professional when it comes to taxes. The reason: the tax efficiency often generates otherwise ignored savings that more than compensate for the professional's fee. For example, many investors are unaware that realized losses on investments, that is, money lost after selling a stock for less than it cost, can be used to offset taxable gains. This is called "tax loss harvesting."
Ordinarily, an investor will pay either a long-term capital gain tax (securities held over one year) or short-term capital gain tax (securities held for less than one year). If it's a long-term capital gain the investor will pay either 0%, 15%, or 20% depending on their income level and their filing status (single, married filing jointly, married filing separately). Short-term capital gains are taxed as ordinary income. These rates range from 10% to 37% again, depending on your income level and filing status. You can find out exactly what percentage of long and short-term capital gains tax you'll pay by visiting FactCheck.org
Do Your Homework – We live in an ocean of information, so take a dip! While some investments may obscure their costs in the fine print, anyone can quickly get to the bottom line with the wealth of information available online. There’s no excuse for investing in an asset without knowing the full costs.
Exercise Tax Efficiency – Saving isn’t just about fees, it’s also about taxes. Investors might be surprised to see how much they hold on to with a tax-deferred, or tax-exempt account. Tax-deferred accounts, which safeguard investments from taxes as long as the assets remain untouched, include 401(k)s and traditional IRAs. These account options are great ways to save big on burdensome taxes. However, there’s a catch. As mentioned earlier, you’ll lose the tax advantage (and get hit with penalty costs) if you withdraw money early. What does “early” mean? Any withdrawal taken from a 401k or an IRA (both traditional and Roth) before the age of 59½ is early. Younger investors should consider Roth IRA accounts. Provided you have owned the Roth for five years, both earnings and withdrawals made after 59½ are tax free. These are great ways to save over the long-term if you know you won’t need to touch the money.